Imagine trying to get to a heap of dollars left on the road, but a swamp separates you from the money.
Let’s assume there were planks of different solidity and length bridging the space, each leading to cash piles of different volumes stacked on the other side. How would you cross the bridge to collect a pile?
I guess you would test the woods to see which is strong enough to hold your weight, long enough to safely cross you, and leads to one of the biggest cash piles.
This hilarious example of seeking the best potential reward of a move at the minimal risk to you is exactly what a risk-to-reward ratio helps you do. Simply put, a risk-to-reward ratio that tells you how much risk you are taking for how much potential reward.
In finance, investors and traders often calculate this ratio and use it as a guide to making several market moves. They seek out the best investment or trading potential yields at the lowest potential risks to their capital. If you day trade cryptocurrencies and are keen to learn how you can do this yourself to boost profitability, then read on.
What Is A Risk To Reward Ratio?
Risk to reward ratio (also called R/R ratio or RRR) measures how much risk a trader or investor is taking for how much potential gains on a particular trade.
The ratio (expressed as X:Y) shows what the trader would gain for each unit of risk he takes on a market move. For example, a 1:5 risk to reward ratio suggests that for each $1 you risk on the trade, you can possibly earn $5.
Notice that in our swamp story, we mentioned checking your body weight against the solidity of the planks? That’s because the risk/reward ratio of every trader is largely based on the trader’s risk appetite.
A 1:7 R/R ratio indicates a trader with a larger risk appetite compared to a 1:2 R/R ratio. Since making $2 on $1 is considerably easier than making $7 on a dollar, the lower the risk/reward ratio, the better your chances of reward per unit of risk.
A trader’s risk appetite usually influences the parameters he sets per trade. These parameters – among other things – come down to setting profit targets (potential reward if the trade is successful) and stopping losses (potential risk if you lose the trade) before entering a trade. The ratio is then calculated by simply dividing the potential risk by the net profits earnable on the trade.
Before we capture a detailed picture of how this works, it’s important to understand the two elements that make up the ratio – Risk and Reward.
How To Determine Risk And Reward
Risk In Trading
Risk is simply how much of your investment you can lose given the outcome of a particular position.
If you bet $100 on the price movement of a currency pair in forex, for example, your risk is how much of that $100 you can lose if the market moves against you.
Risk exists because there is no guarantee that the market will agree with your price predictions. The initial risk on any trade is 100% of your investment. Good traders mitigate this by setting up stop losses, which are essentially the limit of loss they can bear on a losing trade.
When you set a stop loss on a trade, you’re ordering your position to be automatically closed once prices hit a predetermined level against your prediction. So instead of losing all of your $100, a 10% stop loss helps you exit the trade automatically once losses hit $10.
In real trades, you first need to pinpoint your entry price, then you calculate potential risk like this:
Entry Price – Stop Loss Target = potential risk
Reward In Trading
Reward is the opposite of risk, and it indicates how much you can make from trade if the market moves in your favor. Using our forex example, if you bet $10 on a trade, your reward is how much profits you expect to earn on that $10.
Some brokers set a cap on possible profits per trade on their platform, usually between 80% to 90%. On open trading platforms like Binance (for crypto) or MT4, rewards per trade can shoot up to 200%, 500%, or more, especially with the help of margins.
Good traders know gains do not sustain forever and so set a profit target, at which point they will exist a trade with their gains. This is called ‘take profit,’ and it’s the difference between the profit target and the entry point. Take profit is the trader’s ‘potential reward’ on trade and is mathematically expressed as:
Profit target – Entry Price = potential reward
How Risk To Reward Ratio Works
Now that you understand ‘risks’ and ‘rewards’, how do you calculate the R/R ratio before entering a trade or investment?
You start by setting how much you’re willing to lose (a stop-loss point) and how much you can expect to gain (a profit-target point) from the trade.
It’s important to note that these figures are not just determined over the top of your head. A decent amount of technical and fundamental analysis should influence your risk and reward setups.
Once you’ve marked your entry point, you can calculate the R/R ratio by working out:
(Entry point – Stop-loss point) / (Profit-target – Entry point) = R/R ratio
Let’s assume you buy a stock at a $55.50 entry price and set your stop-loss at $55.40 and a profit target at $55.80; your R/R ratio is:
($55.50 – $55.40) / ($55.80 – $55.50) = $0.10 / $0.30 = 0.33.
This means you can gain three times the amount for every $1 risked.
Another way to calculate this is simply by determining your risk and reward in percentages. For example, you can settle for a 15% reward on trade and set the stop-loss at 5%. Your risk-reward ratio works like this:
Risk percentage / Reward percentage = Risk/Reward ratio. That is, 5/15 = 1:3 = 0.33.
Risk Vs. Reward: Asymmetric Opportunity
When it comes to applying risks and rewards to trading, the real question is how do you assess trade positions so that you stand to gain more than you stand to lose when you enter a trade? That is, how do you ensure your potential reward exceeds potential risks?
Consider this: What are your potential risks if I were to offer you $1000 in stock to run goal-to-goal across a football pitch during an ongoing match? You could surely be picked up by security if you get caught along the way. However, if you succeed and make it to the other goal, you get $1000 in stock.
Let’s say I up my offer a bit higher to $1200 worth of stock if you could run goal-to-goal across the pitch, this time, without clothes. Now your risk not only involves being taken away by security but also having photos or videos of your naked butts posted on the internet by anyone (you’re without clothes, for goodness sake!).
You’d agree that both deals are risky. However, the second deal is far riskier than the first for a meager increase in the potential gains. Taking option one, therefore, seems like the best decision in this case.
The best use of risk-reward ratios in trading is looking for trade setups where the potential upside is far greater than the potential downside. This is called asymmetric opportunity, and good traders incorporate it into their trading strategy.
Mathematically, if your ratio is larger than 1.0, the trade’s potential risk outweighs its potential gain. You probably shouldn’t enter it. Where the ratio is less than 1.0, your potential profits surpass potential loss.
To increase your chances of profitability, your trade setups should make you at least three times more than you are risking. That’s a 1:3 R/R ratio. This ratio alone can give you a greater chance of staying profitable, all things being equal. However, nothing is ever guaranteed.
Now, let’s apply all we’ve learned so far in a typical crypto day trading example.
Applying The Risk/Reward Ratio To Crypto Day Trading
Day trading cryptocurrency involves entering and exiting crypto trades multiple times within 24 hours, either in one market or multiple markets. Developing a sound risk/reward ratio and win/loss ratio is crucial for ensuring day-to-day profitability in crypto trading or at least turning a profit weekly.
Let’s assume you want to enter a long position (to profit from an uptrend market) after careful technical analysis of the market.
You determine your entry point and set your take profit order at 15% of your trading amount from entry (profit target – entry point). Then you check the market circumstances that could negate your trade setup. You settle for a 5% loss order (entry price – Stop loss target = stop-loss) on the trade.
With risk and reward percentages figured out, your risk/reward ratio is 5/15 = 1:3. As explained above, this ratio sets you up to gain up to 3 profit units for every $1 risked.
Assuming we are working with a $100 trading amount on this setup, let’s take a hypothetical 6-trade session and see what happens to your profit button line.
|Number of trades||Trading amount||Losses||Wins|
As the table shows, even with a 1:3 R/R ratio and winning only 50% of your trade, you still turn a +$45 profit on your $100.
In reality, however, a 1:3 risk to reward ratio may not be enough safety net, especially when applying pip spread to your setup in foreign exchange trading. R/R ratios are never meant to be static. Depending on the time frame, your entry/exit points, trade environment, and other market circumstances, your risk-to-reward ratio should be adjustable anytime to accommodate.
Pros And Cons Of Using Risk/Reward Ratio
Calculating risk/reward ratios is an important risk management practice given the volatility of crypto markets. To help you understand why risk to reward ratio alone isn’t enough to guide entire market moves, we’ve spelled out the pros and cons of using this tool.
Pros of Risk to Reward Ratio
- R/R ratio helps you know at any time the potential benefits trade can bring versus the probable risks accrued to you.
- It helps you assess the best possible trade setup so you can stand to gain more than you can lose per trade.
- It helps advanced traders better modify their trading strategies by analyzing the efficiency of R/R ratios over a period.
- Since risks and rewards are determined based on the trader’s risk tolerance and price movements, there’s a large room for errors. R/R ratio is therefore not always accurate.
- R/R ratio does not quite tell you everything you need to know about a trade. Frankly, you would have to consider the ‘likelihood’ of achieving targets given a host of market circumstances surrounding each trade.
- Applying risk/reward ratios to financial instruments such as derivatives can be tricky. These assets are notorious for moving in the opposite direction of their base assets and can render R/R ratios useless.
Mistakes Day Traders Make With Risk/Reward Ratio
One common mistake most day traders make when applying the R/R ratio is having an already premade ratio in mind before analyzing a trade.
This is dangerous as it often leads traders to establish their take profits and stop losses based on the entry point alone or pure greed, without analyzing market conditions surrounding that trade. Failure to ascertain trade security often results in losses.
Even with the best risk/reward ratios at hand, it is crucial to ensure other market forces such as news, pumps, and dumps of related assets, timeframes, and more will not hamper your trade from reaching its target.
To get the best out of your ratio, your trading plan needs to establish these key things:
- Favorable market situations at the time
- The best entry point
- Where to place your stop-loss and profit targets under those market conditions
- When to adjust stop-loss and profit targets given market conditions
Other risk management ratios you can use to measure trade setups along with risk/reward ratio are: break-even percentage and win/loss ratio.
Have any thoughts on the Risk/Reward ratio? Let us know in the comments.