The risk/reward ratio represents the amount of return that an investor can expect for every buck he or she risks on an investment. Investors use risk/reward ratios to compare the potential returns of an investment with the amount of risk they must take to earn those returns. Traders use this ratio to determine which trades to take, and it is calculated by dividing the amount a trader stands to lose if the price of an asset moves in an unexpected direction by the amount of profit the trader expects to make after closing the position.
How does the Risk-Reward Ratio work?
It is often found among market strategists that the ideal risk/reward ratio for their investments is approximately 1:3, or three units of expected return for every unit of additional risk. By using stop-loss orders and derivatives such as put options, investors can manage risk and reward more directly. When trading individual stocks, one often uses the risk/reward ratio as a benchmark; however, different trading strategies have different optimal risk/reward ratios. Usually, a certain amount of trial-and-error is required to determine the right risk/reward ratio for a given trading strategy, and many investors have a pre-determined risk/reward ratio for their investments.
How Can You Interpret the Risk-Reward Ratio?
It allows traders to manage their risk of losing money on trades even if they have some profitable trades. A trader will lose money over time if their win rate is below 50%. The risk/reward ratio is the difference between the entry point for a trade and the entry point for a sell order. Comparing these two values gives the profit versus loss ratio, or reward to risk ratio.
When trading individual stocks, investors often use stop-loss orders to help minimize losses and manage their investments based on risk and reward. Whenever a stop-loss order is placed on a stock, it automates the selling of the stock, if it reaches a certain low, from the portfolio. In general, investors do not require exorbitant additional trading costs to set their stop-loss orders through brokerage accounts.
Limiting Risk and Stopping Losses
If you’re not an inexperienced investor, you would never let that $500 reach zero. Your risk isn’t the entire $500. Investors always set a stop-loss or maximum downside price to minimize their risk. If you set a $29 sell limit price as the upside, you might set $20 as the maximum downside. Whenever the stop-loss order reaches $20, it is sold and you look for another opportunity. Because we limited our downside, we can now change our numbers a bit. Your new profit stays the same at $80, but your risk is now only $100 ($5 maximum loss multiplied by the 20 shares that you own), or 80/100 = 0.8:1 which is still not ideal.
Conclusion
A wise investor knows that hoping for the best is a losing proposition. Being more conservative with your risk is always better than being more aggressive with your reward. You must calculate risk versus reward realistically and cautiously.
