What is the risk/reward ratio?

How does the risk/reward ratio work?

The risk/reward ratio is a tool that investors can use to compare potential profits and potential losses of an investment. The risk/reward ratio works by comparing the potential losses of an investment to the potential profits. If you can calculate the potential risk and reward of the trade, all you have to do is divide the risk by the reward to find the ratio. This ratio can be used alongside other ratios, such as the win/loss ratio, to help make investment decisions.

How to calculate the risk/reward ratio

To calculate the risk/reward ratio, use this formula:

Potential loss / Potential gain = Risk/Reward ratio

Note: Some investors use the reward/risk ratio, which reflects the formula mentioned above. However, for the reward/risk ratio, higher numbers are better for investors.

Example of the risk/reward ratio

Imagine that XYZ is currently trading at $50 per share. You believe it will rise to $60. You buy 100 shares at $50 and set a stop-loss order at $45. In this scenario, the potential profit (reward) is $1,000 ($10 per share multiplied by 100 shares). The potential losses equal $500 ($5 per share multiplied by 100).

The risk/reward ratio for this investment would be $500 / $1,000 = 0.50.

Note: A risk/reward ratio of less than 1 indicates an investment with a reward greater than the risk. Ratios higher than 1 indicate investments that carry more risk than the potential reward. A ratio equal to 1 indicates equal risks and rewards.

Alternatives to the risk/reward ratio

The risk/reward ratio is one tool traders can use to analyze investment opportunities. Day traders often use another ratio, which is the win/loss ratio, to think about their investments. This ratio measures the number of trades that make a profit compared to the number of trades that result in a loss.

For example, an investor who makes 10 trades, five of which are profitable and five of which result in a loss, would have a win/loss ratio of 50%.

The higher the win/loss ratio for the investor, the more risk they can take on individual trades, as these trades are more likely to be successful, provided that they exercise the same level of care and study when making investment decisions.

Investors with low win/loss ratios should focus on investments with lower risk/reward ratios to ensure that their profits from successful trades exceed the losses from repeat unsuccessful trades.

Advantages and disadvantages of the risk/reward ratio

Advantages:

• Easy to calculate: The risk/reward ratio uses a very simple formula, meaning that investors can easily use it to make quick decisions.
• Helps in risk management: The ratio describes the risks of the investment, giving the investor more information to determine whether or not to make a trade.

Disadvantages:

• May not be completely accurate: Risk/reward ratios are determined using potential profits and stop-loss orders set by the investor. A security can rise or fall in price so quickly that an investor cannot sell at the desired price, meaning that the actual profit or loss may exceed the theoretical profit or loss.
• Does not take into account potential chances for profit or loss: The risk/reward ratio only considers the potential profit and the loss that can result from the investment. It does not indicate anything about the likelihood of either outcome occurring.
• Considers

To binary outcomes without considering stable prices: Securities can rise or fall in price, but they can also remain constant. The risk/reward ratios do not take this possibility into account, which is a disadvantage for day traders who wish to make repeated trades.

What does this mean for individual investors?

Individual investors can use the risk/reward ratio when considering whether to make a trade. You can also use the ratio to make decisions about where to set price targets or stop-loss orders to create a trade that has the desired risk/reward potential.

For long-term investors, the risk/reward ratio is of less value as they are more likely to hold stocks through a series of price fluctuations.

Frequently Asked Questions (FAQs)

What is a good risk/reward ratio?

A risk/reward ratio of less than 1 indicates an investment with a greater reward than risk. Conversely, ratios above 1 indicate investments that carry more risk than potential reward.

How can you calculate the risk/reward ratio?

The calculation to determine risk versus reward is simple. Just divide the potential loss (risk) by the potential gain (reward).

How can the risk/reward ratio be used in investing?

These ratios are typically used to make quick buy or sell decisions in the market. Any decision regarding risk/reward depends on the quality of research done by the investor. The appropriate risk criteria (i.e., the money the investor can afford to lose) and the reward criteria (the expected rise in the investment portfolio that the investment can achieve) should be defined.

Sources

The Balance only uses high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we verify facts and maintain the accuracy, reliability, and quality of our content.

IG. “What is risk and reward for traders and investors and why does it matter?”

Charles Schwab. “Learning from your losers.”

SoFi. “How to use the risk/reward ratio in investing.”

Source: https://www.thebalancemoney.com/risk-to-reward-ratio-1031350