What is ‘risk’? Every time you participate in a volatile financial market, there is some associated risk. The risk here pertains to your capital. And there is no way to completely eliminate the risk. Does that mean that you do not take any risks or do not participate in financial markets? Definitely not! Every market participant who takes a risk wishes to get a reward that outweighs the risk that was taken.
Well, that being said, risk, to be precise, risk-reward ratio, is the subject we are going to talk about in today’s article. However, this is not uncommon for individuals investing in the stock market. The risk-reward ratio is the prerequisite of any trading/investing strategy as it helps in limiting the inherent risks of your investments.
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What Is the Risk-Reward Ratio?
The risk-to-reward ratio is used to assess a trade’s potential to earn profit vs. the potential loss it can generate. In simple words, it is the amount of risk a trader or investor can take to earn a certain amount of profit. Traders and investors use this extensively to book profits and losses.
A stop-loss plays a crucial role in determining the risk-reward ratio. You generally use a stop-loss order to exit the position in case the price moves in the opposite direction. This helps traders and investors manage risk effectively.
The risk-reward ratio determines whether the expected returns are sufficient to cover the risk. In short, it helps an investor decide whether the trade is worth taking or not.
How Do You Calculate Risk-Reward Ratio?
To calculate risk to reward ratio, you first need to know the potential profit or loss you want to generate based on your capital. You are free to set this limit based on your own preferences and risk-taking ability.
To help you set in this journey, here is the formula to calculate this ratio:
Risk to reward ratio = (Entry price – Stop loss price) / (Target price – Entry price)
For example, let’s assume you are entering into a trade at a price of Rs.100. You place the stop-loss at Rs. 90 and decide to book a profit at Rs.120. Hence, on this trade, you are taking the risk of Rs.10 for a potential profit of Rs.20.
Putting these variables in the formula looks like below:
Risk – to reward ratio = (100 – 90) / (120 – 100)
= 10 / 20
= 1 / 2
Hence, the risk-reward ratio for this trade is 1:2.
This also means to earn every Rs. 2 in profit, you are willing to take the risk of Rs. 1.
It should be kept in mind that these numbers are based on a random bias taken as an example. An ideal risk-reward ratio should be set based on the market analysis, security analysis, and your capital contribution. This ratio is very personal and varies from person to person.
What Is the Ideal Risk-to-Reward Ratio?
Now that we have established the fact that risk to reward ratio is each to their own, an ideal risk-to-reward ratio is what is ideal for you based on your preferences.
The bottom line is to enter a trade where the profit potential exceeds the loss potential. For instance, a risk-to-reward ratio of 1:4 states that you are ready to risk Rs. 1 for every potential gain of Rs. 4.
In India, a majority of traders prefer risk to reward of 1:2. Meaning for every Rs. 2 in profit, they are willing to risk Rs. 1. However, this should not be construed as a benchmark and followed blindly.
Even experienced traders change their risk-to-reward ratio based on changing market conditions. The key is to stick with your determined ratio, factoring in various variables and compounding your capital.
Novice traders can choose to have a ratio of less than 1. The best risk-to-reward ratio can only be determined after practicing your trades in various market conditions. You may make mistakes, but you will also learn.
What Should You Do After You Have Computed the R/R Ratio?
Once your risk-to-reward ratio is determined, it’s time to put it into practice. To implement a risk-to-reward ratio for your trades, make sure to place the stop loss and exit order in the ratio you determine for yourself.
For instance, you want to enter the trade at Rs. 300 with a risk-to-reward ratio of 1:2. Thus, you are likely to place a stop loss order at Rs. 290 or 280 and an exit order (price at which you’ll book profits) at Rs. 320 or 340. This will ensure a 1:2 risk-reward ratio.
You have to decide how much you are willing to risk for a particular trade and determine your exit price based on the same or vice-versa.
If the price starts falling, your stop-loss is executed, and the loss will be Rs. 10 or Rs. 20 per share based on what you’ve set.
Similarly, if the price starts to rise and your exit order gets triggered, then you would make a profit of Rs. 20 or Rs. 40 per share based on the order being set.
Investing involves potential risks and rewards, and it is on you to determine the ratio and implement the same. Trading without calculating this ratio is like driving a car without any destination in mind. For novice investors and traders, a risk-to-reward of 1:1 or 1:2 can be a good starting point. You can start experimenting with different numbers for this ratio once you gain some experience.
Once you have calculated the risk-reward ratio, you can place a stop loss and exit order. Remember, this ratio can change subject to market dynamics and your own experience and preferences.
1. What do you mean by stop loss?
A stop loss (SL) for a normal buy order is an order where the price is set below the current market price. This order’s objective is to limit the investor’s losses. For example, if an investor purchases a share for Rs. 100, then he/she can place the SL at Rs. 95 (though subject to their own constraints) to limit losses. Similarly, if an investor has placed the sell order at Rs. 120, he/she can place the SL at Rs.125. The trade will conclude with marks of Rs. 95, and Rs. 125 gets hit, limiting the loss to Rs. 5.
2. What decision can be made based on the risk-to-reward ratio?
A risk-to-reward ratio greater than 1 implies that you are taking more risks compared to the potential rewards you can earn from the trade. Similarly, if the ratio is less than 1, the rewards outweigh the risks. This will help you gauge your capital requirements and preserve the same for your trading or investments. You can make decisions regarding how much capital you can lose and how much you can compound from this ratio.
3. Is risk-to-reward ratio crucial in trading?
One cannot emphasize enough the vitality of this ratio. Risk to reward ratio not only helps you in containing losses and booking gains but also helps you keep your emotions in check. A human brain can be swayed easily when the market moves in a different direction. The RR ratio helps you to stay disciplined with your trading and investing journey, limits your losses, and helps you avoid short-term market noise.