Should I risk my time in return for the information in this article?

The risk-reward ratio can reflect the corresponding risks taken to obtain a certain potential return.

Good traders and investors choose their bets very carefully. They seek investments that minimize potential disadvantages and maximize potential advantages. If one investment can provide the same benefits as another investment but with less risk, it may be a better choice.

Are you interested in learning how to calculate your own risk-reward ratio? Please read this article to find out.

Introduction

Whether you choose day trading or swing trading, there are some things you should know about the risks basic concepts. These can give you some preliminary understanding of the market and provide you with a basis for guiding your trading activities and investment decisions. Otherwise, you will not be able to protect the funds in your trading account and grow them.

We have discussed risk management, position sizing, and setting stops. However, there are some crucial things you need to know if you adopt an active trading strategy. How much risk is associated with the potential reward? What are your potential strengths and weaknesses? In other words, what is your risk to reward ratio?

In this article we will discuss how to calculate the risk-reward ratio of a trade.

What is the risk-reward ratio?

The risk-to-reward ratio (expressed as the R/R ratio or R) calculates the corresponding risk a trader takes to obtain a certain potential reward. In other words, it reflects the potential return you get for every $1 you invest.

The calculation itself is very simple, just divide the maximum risk by the net target profit. What should be done specifically? First, look at the price level at which you want to start trading. Then, decide where to take profit (if the trade is successful) and where to place your stop loss (if the trade is losing). This is crucial if you wish to manage risk in an appropriate manner. Good traders set profit targets and stop losses before starting a trade.

Now that you have identified your entry and exit target points, you can calculate your risk-reward ratio. Just divide the potential risk by the potential reward. The lower the ratio, the greater your potential return per "unit" of venture capital. Let's find out how it actually works.

How to calculate risk reward ratio

Suppose, you want to open a long position on the Bitcoin platform. After analysis, you determine to take profit at a price 15% higher than the entry price. At the same time, you will also ask the following questions. At what price level will your trading idea fail? That is where you plan to place your stop loss order. In this example, you decide to set the failure level to be 5% below the entry price.

It is worth noting that this percentage cannot usually be chosen arbitrarily. You should determine when to take profits and losses based on your analysis of the market. Technical analysis indicators can help you do this.

Now, our take-profit target is 15%, and the control point for potential losses is 5%. What's the risk-reward ratio? Calculated: 5/15 = 1:3 = 0.33. It's that simple. This means that for every unit of risk invested, we have the potential to triple the return. In other words, the risk we take on per dollar may also be magnified three times. So, if we hold a position worth $100, we might gain $15 in potential profit at the cost of a $5 loss.

We can lower this ratio by moving our stop loss closer to the entry price. However, as we said, entry and exit positions should not be calculated based on arbitrary numbers but should be based on rational analysis. If a trading portfolio has a high risk-to-reward ratio, it may not be worth trying to "game" the numbers. Might as well keep looking for other setups with a good risk to reward ratio.

Please note that positions of different sizes may have the same risk-to-reward ratio. Therefore, if we hold a position worth $10,000, we gain a potential profit of $1,500 at the expense of a loss of $500 (the ratio is still 1:3). The ROI only changes when we change the relative positions of the take profit target and the stop loss.

Risk to reward ratio

It is worth noting that many traders will go in the opposite direction To do this calculation, calculate the reward-risk ratio. Why do this? In fact, this is just a personal preference. Some people find it easier to understand this way. Its calculation is the opposite of the risk-reward formula. Therefore, our reward-to-risk ratio in the above example is: 15/5 = 3. As you can imagine, a high reward-risk ratio is better than a low reward-risk ratio.

Example of a trading portfolio with a return-risk ratio of 3.28.

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Risk and reward analysis

Suppose we make a bet at the zoo. If you sneak into an aviary and hand-feed a parrot, I'll give you 1 Bitcoin. What are the potential risks of doing this? The risk is that you do something you shouldn't and could be picked up by the police. But if you succeed, you will get 1 Bitcoin.

At the same time, I also propose an alternative. If you sneak into a tiger cage and feed the tiger raw meat with your bare hands, I will give you 1.1 Bitcoins. What are the potential risks of doing this? Of course you may still be picked up by the police. But you can also be attacked by a tiger and be fatally injured. On the other hand, the payoff is a little better than the gamble of feeding a parrot. Because if you succeed, you get more Bitcoins.

Which one looks more cost-effective? Technically speaking, none of them are a good deal, since you're not supposed to sneak into the zoo. Still, with the tiger-feeding bet, you're taking more risk for only a little more potential reward.

Similarly, many traders look for combinations of trades in which their gains exceed their losses. This is called asymmetric opportunity (potential advantages outweigh potential disadvantages).

Another thing to mention here is your win rate. Your win rate is the number of winning trades divided by the number of losing trades. For example, if your win rate is 60%, it means that 60% of your trades are profitable (here is the average rate). Let's take a look at how to apply this ratio in your risk management.

Even so, some traders are able to achieve high profits with very low win rates. Why is this? Because the risk-reward ratio of their individual trading portfolios matches it. If they only choose a 1:10 risk-to-reward combination, they could lose nine trades in a row and still break even on the remaining trade. In this case, they only need to win two out of ten trades to make a profit. This is the power of risk versus reward calculations.

Summary

We have covered what risk reward ratio is and how traders can incorporate it into trading intend. To understand the risk profile of any money management strategy, it is necessary to calculate the risk-reward ratio.

When it comes to risk, you should also consider keeping a transaction log. By logging trades, you can get a more accurate picture of how your strategy is performing. Additionally, you can apply it flexibly to different market environments and asset classes.