Investment or trading is a long-term skill. It takes you a few good years to understand the nuances and master them. On the way, you learn several tools and techniques to manage, maintain and grow your portfolio.
Risk Management is one of the most powerful techniques used by pro investors. And one of the most essential tools for Risk Management is the Risk to Reward Ratio. Risk-Reward Ratio is used to decide whether a trade or an investment is worth considering or not.
So, let’s understand more about it, how it is calculated, and how you can use it in your trading or investment strategy.
The risk-reward ratio compares a potential loss on investment with the potential profit. In simple words, it’s the measure of Risk taken for investment with its corresponding Reward.
Let’s understand this with an example.
A risk-reward ratio of 1:3 means that an investor is willing to risk $1 of investment for the possibility of earning $3. Similarly, a risk-reward ratio of 1:5 implies that the investor is willing to risk $1 of investment to earn $5.
Similarly, traders also use the risk-reward Ratio to decide the trades they want to take or leave.
The formula for calculating the Risk-Reward Ratio is as follows:
Risk-Reward Ratio = (Possible Loss from the Investment) / (Possible Profit from the Investment)
So, in case the price of BTC falls, the stop loss would be triggered, and you would lose $5,000 [$35,000 (Sell Price) – $40,000 (Buy Price)]. Hence, the possible loss from the investment is $5,000.
Further, if the price of BTC rises and reaches $50,000. Then you would gain $10,000 [$50,000 (Sell Price) – $40,000 (Buy Price)]. Hence, the possible profit from the investment is $10,000.
Therefore, the Risk-Reward ratio in this case is 1:2 ($5,000 / $10,000).
There are two types of Risk-Reward Ratios:
It is the Ratio that an investor is willing to tolerate. Every investment has an inherent risk. This Ratio explains the risk an investor is ready to take to earn the reward on investment. This Ratio can vary from investor to investor.
This is the actual risk of investment. The above example shows how an actual Risk-Reward ratio is calculated.
So, if the Actual Risk is less than the Expected Risk, the investor would consider investing.
However, if the Actual Risk is less than the Expected Risk, the investor would skip the investment.
Suppose John’s Risk-Reward Ratio is 1:2. He got an investment proposal, and he is contemplating whether to invest or not.
If the investment has a Risk Reward Ratio of 1:1 (greater than 1:2), he should reject the proposal.
However, if the investment has a Risk-Reward Ratio of 1:3 (less than 1:2), he can consider the proposal.
The benefit of the Risk-Reward Ratio is that it allows an investor or trader to manage their portfolio risk. A person can safeguard himself from taking too much risk for too low a reward.
However, it has a limitation as well.
Risk-Reward Ratio cannot be used in isolation. It needs to be used with other tools and techniques to make a successful investment decision.
Several other factors should also be considered, such as:
So, this is how you can calculate Risk-Reward Ratio and incorporate it into your investment strategy. Further, we understand that by learning proper portfolio risk management, you can save yourself from burning hands.
We hope this post is helpful to you. Let us know if you want us to cover more Risk Management tools. Further, let us know your feedback and comments.
Please note that nothing written in the post is a financial advice. Please consult your financial advisor before making any trading or investment decision.
Portfolio Risk Management is a process of measuring and managing the risk of an investment or trading portfolio.
The Risk-Reward ratio compares a potential loss on investment with the potential profit. In simple words, it’s the measure of Risk taken for investment with its corresponding Reward.
Risk – Reward Ratio = (Possible Loss from the Investment) / (Possible Profit from the Investment)
If Actual Risk-Reward Ratio < Expected Risk-Reward Ratio, consider the investment proposal.
However, If the Actual Risk-Reward Ratio > Expected Risk-Reward Ratio, reject the investment proposal.