Risk-Reward Ratio

What is the Risk-Reward Ratio?

The risk-reward ratio is the measure that is used by the investors during the trading for knowing their potential loss with respect to the potential profit out of the trade and hence used by the traders for effectively managing their risk and capital during the trading process. If the risk-reward ratio is 1:4, then it implies that the investor is ready to risk $1 for a potential gain of $4.

Explanation

Risk-Reward-Ratio

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Source: Risk-Reward Ratio (wallstreetmojo.com)

Risk-Reward Ratio Formula

In order to calculate the risk-reward ratio, the investor firstly has to determine the risk involved in the transaction. After determining the risk, it needs to determine the expected rewards which it will be getting after undertaking the involved potential risk of loss of the money invested by him. Lastly, after determining the potential risk and expected rewards, the risk-reward ratio will be calculated by dividing the potential risk by the expected rewards in trading. The formula is:

Risk – Reward Ratio = Potential Risk in Trading / Expected Rewards

Examples of Risk-Reward Ratio

  1. For example, the investor, after conducting the research of the market and analyzing the stocks of the various companies, expects that the price of the stock of the company AB will go to $ 200 per share from its current price of $ 180 per share and after reaching the point of $ 200 per share, the investor would sell the shares.
  2. Along with this, he expects that if the share price goes downwards beyond $ 170 per share, then there are chances of huge potential loss, so he thinks of limiting his risk up-to $ 170 per share only by placing the stop loss on the order of $ 170 per share. Calculate the expected Reward per share, potential risk per share, and the risk-reward ratio of investing in the share of company AB.

Answer

In the present case, it is given that the current price at which the stock will be executed is $180 per share, and thus it is the entry point price of the trade. The investor expects that the prices of the stock will go up to $ 200 per share, and at that point, he will sell the shares. So, the expected Reward of the deal is:

Expected Reward = Expected Price Target of the Stock – Entry Point Price of the Stock
  • Expected reward = $ 200 per share – is $ 180 per share
  • Expected reward = $ 20 per share

Also, the investor decides to place the stop loss to the order of $ 170 per share. So, the potential risk of the trading will be the difference between the entry price per share and the stop-loss order value of the stock.

Potential Risk = Entry Point Price of the Stock – Stop-Loss Order Value of the Stock
  • Potential Risk = $ 180 per share – $ 170 per share.
  • Potential Risk = $ 10 per share

Finally, the risk-reward ratio from the investment per share will be calculated by dividing the expected rewards by the potential risk in trading using the below formula:

Risk-Reward Ratio = Potential Risk in Trading/Expected Rewards
  • = $ 10 per share/$ 20 per share
  • = 1:2

Thus the risk-reward ratio of the expected investment is 1 in 2. Since the ratio is less than 1, it indicated that with the given risk, investment has the potential of giving a double return.

Importance

  1. The risk-reward ratio helps the trader in managing the potential risk of loss of the money invested by him.
  2. It provides an idea to the investor than what is the expected return it could generate with the given level of risk, and accordingly, the decision can be taken. Thus, it will help the investor in making the decision according to his risk-taking capacity.

Conclusion

The risk-reward ratio provides the measurement of the expected rewards which the investor is going to generate with the given level of the potential risk. This ratio is very helpful for investors while making decisions with respect to their trading investment. So, the investment will be made by the investor according to his own capacity on the basis of this ratio.

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