Risk/Reward Ratio 101: Everything You Need to Know
In trading, the risk-reward ratio (risk/reward ratio) is a key concept. Whether your are a technical or fundamental analysis trader focusing on short-term or long-term strategies, understanding the risk/reward ratio-and how it is applied to each trade-will improve your trading. To utilize risk/reward ratios effectively you’ll first need to establish the risk and reward potential of each trade, and then assess the risk/reward in combination with the probability of a successful trade. This helps you determine if a trade is worth taking or not. Here’s how to do it.
In theory, a risk/reward ratio is a simple concept. If you risk $1 to make $2, your risk, if you lose, is half of your potential reward if you win. The risk/reward ratio is $1/$2 (or risk divided by reward), which equals 0.5. The lower the risk/reward ratio, the smaller the risk is relative to the potential reward. If the ratio is above 1, then the risk is greater than the potential reward.
The risk/reward ratio is more complex in trading. How do you know what your risk is? How do you calculate your potential reward? Understanding the answers to these questions will help you utilize the risk/reward ratio effectively, making you a better trader.
Risk/Reward Ratios - The Risk Portion
The risk/reward ratio makes you think in terms of risk and profit potential, which are both affected by the entry price. Each element must be considered in order to formulate a trade with a good risk/reward ratio.
Risk is determined at the outset of the trade using a stop-loss order. Risk is the difference between your entry price and stop-loss price, multiplied by the position size. For example, if you buy a stock at $20, and place a stop-loss order at $19, you are exposed to $1 of risk per share. If you buy 100 shares, then your risk is $100.
A stop-loss should not be randomly set. Rather, set it at a location that shows that you are wrong about the trade (at least for now). When buying, a stop-loss is often set below a “swing low” on your price chart. When a price is moving down, and bounces off a certain price, that is a swing low. Since the price couldn’t go lower than that point, it shows there is some buying interest there. By placing a stop-loss below that level you’re making a calculated assessment that the price will continue higher before it falls through that area of support.
You want the stop-loss as close to your entry as possible in order to minimize risk while still being far enough that it isn’t touched by normal market fluctuations before it starts to move toward the target (discussed next). For additional reading, see 4 Ways to Exit a Losing Trade.
Figure 1. shows an entry and stop-loss method. A trendline is used to estimate where an area of support could develop. Wait for the price to stop falling (during an uptrend) showing the pullback may be over (there are no guarantees in trading). Once the price begins to move back higher, a long entry (buy) is taken, with a stop-loss placed below the recent low.
This leaves a relatively small distance between the entry price and stop-loss price, increasing the likelihood that the trade setup will have a good risk/reward ratio.
Charts courtesy of FreeStockCharts.com
Risk/Reward Ratios - The Reward Portion
With our entry point and risk determined, the reward portion of the trade is considered. The reward is set using a profit-target order. This is an offsetting order (a sell order in the case of the trade above) that closes the trade when the price reaches the profit-target price level.
As with the stop-loss, the profit target shouldn’t be set at a random level.
The profit target is set at a location that is within reach based on normal market movements. In Figure 1., the price is moving within a trend channel. By connecting the major swing lows in price with a trendline we see where the price has shown a tendency in the past to bounce. Similarly, by drawing a trendline that connects the major swing highs we see the general area the price has shown a tendency to stop rising and fall. For this type of trend channel strategy the logical place to put a profit target is just below the top of the channel. If using another chart pattern or strategy, place the target within reach of what the general price tendency has been.
If a bigger move is expected than what has happened in the past, or the trade is being taken for the long term, the profit target may be set outside of the normal market movement. For example, if a stock is trading at $10, but based on some upcoming events you believed it could trade as high as $60 within a year or two, a target could be set at that level. If an asset has been trading in a very small range or consolidation, but volatility is expected to expand, then a target is placed at a location that takes into consideration the expected expanding volatility.
Whether you are choosing a target within proximity of normal market movements, or outside of normal movements because you believed the price could have a big move in the future, always have a reason for why you think the price will reach that profit target level.
Figure 2. shows a potential profit target level just below the top of the trend channel that was used to help find our entry level and stop-loss. With a risk of $2.42 per share, our profit potential-the difference between our profit-target price and our entry price-is $5.88.
The risk/reward ratio on the trade is $2.42/$5.88 = 0.41. The risk is less than half of the potential reward. Therefore, the risk/reward is favorable, so the trade can be taken if it adheres to your trading plan.
Another way to think of it is reward/risk: $5.88/$2.42 = 2.42. Flipping the ratio shows the reward is equal to 2.42 times the risk.
Risk/Reward Ratios - Choosing Trades
Successful trading, contrary to what most people do, does not mean picking the trades you want to take (usually at a random entry point), then applying a risk/reward to it (also usually random). Instead, think of going through a five-part check list to see if a trade setup is worth taking:
- Where is the entry point for the trade?
- Given this entry point, where do I place the stop-loss?
- Where does the profit target go for this trade? Why?
- Only after you’ve defined the above, calculate the risk/reward ratio. By going in this order you get the true risk/reward of the trade, and you can’t fabricate what you want the risk/reward to be.
- Is the trade worth taking based on the risk/reward? If you win 50% of your trades, then in order to be profitable over many trades the risk/reward ratio must be less than 1 in order for you to take a trade. If the ratio is greater than one, skip the trade. If you win less than 50% of your trades, only take trades for which the risk reward ratio is less than 0.67.
Risk/Reward Ratios - Consider the Probability of Success
By following the method outlined above-only taking trades when the stop-loss is placed relatively close to the entry price, and the target is placed within reach of typical price action, providing a favorable risk/reward ratio-your trades have a decent chance at success.
While not always the case, as some fantastic opportunities do occasionally occur, as a general rule the lower the risk/reward ratio, the lower the chance of success on a trade. A trade with a risk/reward ratio of 1 is more likely to result in the target being reached than a trade in which the risk/reward ratio is 0.1.
In the case of the former, the stop-loss and target are both the same distance away from the entry price. In the case of the latter, the target price is ten times further away from the entry price than the stop-loss. In terms of dollars, if you enter long at $20, and place a stop-loss at $19, with a risk/reward of 1.0 the target is at $21. The 0.1 risk/reward requires the target to be placed at $30. Since the $21 target is closer to the entry price, it has a higher probability of success.
Each trader must find a balance between how often they tend to win (win rate) and the risk/reward they opt to use. Many active traders strive to win 50% to 60% of their trades and only take trades that have a risk/reward of 0.67 to 0.25 or slightly lower (profit potential is 1.5 to 4 times the risk).
Practice many trades in a demo account to see what works for you in terms of risk and reward. Practicing is also required to gain skill in choosing your stop-loss locations and profit target levels to maximize your win rate for that trade setup and risk/reward ratio.
The Bottom Line
Risk/Reward is a key trading concept. Many traders use it as the ultimate filter for which trades they take and which they don’t. By establishing your entry, stop-loss and profit targets first, then assessing the risk/reward ratio, you can decide objectively if the trade is worth taking. If the risk/reward is above 1, don’t take the trade. If the risk/reward is below 1 (the reward is larger than the risk), then consider taking the trade if it aligns with your trading plan and capital availability.
Did you know that...
- The concept of 'delayed gratification,' or the ability to wait for rewards, is closely tied to maximizing the benefits of compounding in finance?
- Cagr does not consider the effect of taxes or fees on an investment, which can significantly affect the net return?
- Understanding the historical context of market downturns can give perspective and reduce the fear associated with declines?
- In a rising interest rate environment, dividend-paying stocks might lose some of their appeal as fixed-income assets become more attractive with higher yields?
- Tax-efficient investing strategies aim to reduce tax liability, maximizing post-tax returns?
Quotes of the Day:
- "The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap). The intelligent investor is a realist who sells to optimists and buys from pessimists." - Howard Marks
- "Investing is not a get-rich-quick scheme, it's a long-term strategy." - John Rogers
- "The best investment you can make is in a company with a strong balance sheet." - Marty Whitman
- "The key to successful investing is to have a disciplined approach and stick to your strategy, even when the market is volatile." - Steve Cohen
- "The best investment strategy is to buy when others are fearful and sell when others are greedy." - Robert Rodriguez
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