Risk-Reward Ratio in Trading (Definition, Formula)| How it Works?

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

The risk-reward ratio in the trading is determined by dividing the expected rewards involved in trading with the potential risk. So, the two factors are important for the determination of this ratio i.e., risk and the rewards where risk refers to the potential of loss of the money invested by the investors from the trading and the reward refers to the reward expected by the investor for undertaking the risk potential of loss of the money invested.
These factors are judged or estimated by the investor himself as it will depend on the risk tolerance capacity of the investor. If the ratio calculated is greater than the 1, then it indicates that the risk of the transaction is greater than the expected rewards and if the ratio calculated is less than 1, then it indicates that the risk of the transaction is less than the expected rewards

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 with the expected rewards in trading. The formula is:

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

The ratio is considered by the investors while their trading in the stock as it helps them in assessing their expected return along with the risk associated with such transaction. The ratio varies from one strategy to another i.e., this ratio does not remain the same and differs as per the strategy adopted by the person.
So, in order to calculate the risk-reward ratio, expected return and the risk associated with the same is to be judged by the trader himself. Risk is known mainly on the basis of the stop-loss order i.e., risk will be calculated by calculating the difference between the stop-loss order value and the value at which trade is entered by the investor and the expected return is calculated by calculating the difference between the stop-loss order value and the profit target of the trader.

Examples of Risk-Reward Ratio

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, investor would sell the shares.
Along with this, he expects that if the share price will go 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 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 with 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

The risk-reward ratio helps the trader in managing the potential risk of loss of the money invested by him.
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

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 done by the investor according to his own capacity on the basis of this ratio.