What is Risk to Reward Ratio?

Ram is in standard 10th and he has his boards coming up. But he spends all of his time playing on his PS3. His parents notice this. They tell Ram that they would buy Ram a new PS5, but there are some conditions attached to it. The first one is that he would have to score above 90 percent on his boards to get the PS5. Just when Ram thought this was a good deal for him, his parents put the second condition in front of him. That, in an event where is unable to score the said percentage, he would have to give up his PS3 as well. 

This is where the risk-reward ratio starts in the life of a normal person, even when he is unaware of it. 

But if you are anyway related to finance, you must have heard of these terms quite a few times by now. Does this happen to you that you do not understand how these two are interrelated and what this ratio means? If yes, then you are at the right place. Today we are going to decipher this term in this article. Let’s start by understanding its meaning. 

What is the Risk-reward ratio?

The risk/reward ratio, sometimes referred to as the R/R ratio, compares a trade's possible profit against its potential loss.

A stop-loss order defines risk as the entire potential loss. The entire amount that might be lost is the risk. It's the distinction between the trade's entry point and the stop-loss order. The asset category, investments and trading strategy, and economic variables impacting investment all contribute to risk. 

The entire potential profit, as determined by a profit objective, is the reward. This is when a security is bought and sold. The total amount you might profit from the deal is the reward. The difference between the profit objective and the entrance point is the profit margin. Interest, dividends, and growth in the underlying value of the investment all contribute to the reward. The risk/reward ratio assists investors in deciding between various investment alternatives such as mutual funds, stocks, and hedge funds.

Example:

Let's imagine you decide to invest in ABC stock. You 'purchase' 100 lots, or 100 shares, at ₹20 apiece, for a total position value of ₹2,000, based on the assumption that the share price would rise to INR 30. To guarantee that your losses do not surpass ₹500, you set your stop loss at ₹15.

In this example, you're ready to take a risk of ₹5 per share in exchange for a potential return of ₹10 per share when you close your position. Your reward: risk ratio is 2:1 since you've risked half of your profit aim. Your reward: risk ratio would be 3:1 if your profit aim is ₹15 per share, and so on. As a result, one good transaction may be enough to compensate for two, three (or more) lost trades.

How does the risk-reward ratio work?

The Risk/Reward ratio is normally determined by each trader/investor based on his or her risk appetite. In general, high risk equals great gain, but there is one investment opportunity where this is not the case. This ratio assists the investor in deciding between investment alternatives based on the amount of rewards vs the level of risk involved in the event that the investment does not perform as planned.

Every person has a distinct amount of risk tolerance. The risk/reward ratio assists individuals in choosing and deciding between various investment options based on their ability and projected returns.

The ratio is computed by dividing the amount a trader stands to lose if the price of an asset moves in an unanticipated direction (the risk) by the amount of profit the trader anticipates to have gained when the position is closed (the reward). It's crucial to note, too, that while risk: reward ratios can help you manage your profitability, they can't tell you how likely something is.

Talking in terms of trading, The primary goal of any study conducted before entering the market is to increase the likelihood of initiating a high-probability transaction. You're aiming to maximise a probability by looking for a certain technical pattern. Why? 

Because it appears that it will be followed by a certain price movement. You can increase your chances of discovering a higher-probability transaction by looking for a pattern.

How to calculate the Risk-reward ratio?

To determine the difference between a trade's entry point and the stop-loss order before calculating the risk/reward ratio. This is the ratio's "risk" component. Then find out how much the profit objective differs from the entrance point. This is where the "prize" comes in. The R/R ratio is calculated by dividing the risk by the return.

The risk/reward ratio is calculated by dividing the risk by the benefit.

If the ratio is larger than 1.0, the trade's potential risk outweighs its potential gain. The potential profit is larger than the possible loss if the ratio is less than 1.0.

How to manage risk?

There are four ways to deal with risk.

• Avoid investing after assessing the amount of risk.

• Change in trading/investment strategy, hedging, diversification of investments, and cutting out loss-making investments are all ways to decrease costs.

• Transfer: Risk can be transferred by purchasing insurance and paying a premium.

• Acceptance: Recognizing and accepting risk in exchange for greater rewards.

Advantages

This ratio approximates the potential benefit for an investment versus the risk they are willing to take. It is expressed as a price; for example, a risk/reward ratio of 1:5 indicates that an investor will risk $1 in exchange for the possibility of gaining $5. The anticipated return is the term for this. Calculating risk/reward ratios is an important part of risk management, especially when trading in turbulent markets when the danger is far greater than the possible profit. 

Even if an investment yields a profit, it is critical to determine if the profit received is worth the risk involved. An investor can determine if an investment is worth it or not if the profits are not as expected when compared to the risk. For example, an investor can choose between low-risk investments such as bonds, debentures, and fixed deposits, which provide a lower return on investment, and higher-risk investments such as stocks and mutual funds, which provide higher yields but also carry the chance of loss. An investor's anticipation and risk tolerance influence his or her investment selection.

Disadvantages

The risk/reward ratio is not always precise; the investor must make a judgement based on his or her risk tolerance and specific price movement expectations. Technical and fundamental analysis aid in the better understanding of risk/reward ratios in stocks, but they are not totally correct and still contain assumptions.

The risk-to-reward ratio is based on the expectation of a specific movement, but in fact, financial instruments do not always move in the predicted or opposite direction in the market. When a stock remains unchanged over an extended period of time, it becomes a dead investment with no profit or loss.

Everything aside, There are so many other things to consider while selecting a stock, like keeping risk-balanced so that you can sustain yourself in the market when it crashes. If you are interested in finding out how to make a profitable portfolio, head over to our course for a short but detailed explanation only on Quest.

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Conclusion 

There is always a level of danger while dealing in the financial markets. Before making a deal, investors should evaluate the amount of risk as well as the potential gains, which is known as the resultant 'risk/reward ratio.'

Short-term investors and traders, in general, utilise this ratio to choose from a number of investment categories. This ratio assists them in limiting their losses if the price does not move in the predicted direction.