The Risk Reward Ratio is popular among traders and investors as it is used by them to efficiently manage their profits as well as losses in stock market trading. This ratio also helps a trader identify and fix their target price and risk in a trade.
What is Risk Reward Ratio
To minimize the risk of losing money, this risk-reward ratio plays an important role. It tells us how much risk we should take and how much return or profit we should expect against that risk in the stock market. Everybody wants to be a millionaire overnight but not all have enough experience and knowledge about how the stock market functions, and so they lose their hard-earned money here in the trading. To have successful trading, everybody must understand the importance of risk management in their trade.
What is Risk Management
As its name implies, risk management teaches us to manage the risks associated with trading. We must know how to manage those risks before taking the very first trade in the market. It helps us to decide how much risk of losing money he can take and what will be its effect on his life. Risk management is important for a trader because if he does not know how to manage and bear the risk, it can demotivate him and he can lose a large amount in trading without taking the due profit out of it.
Every individual has a different set of standards for his risk-taking capacity according to his or her risk profile. The risk profile is the one which decides the risk-taking capacity of a trader and it depends on many factors like age, income and saving, responsibility, family health and social status i.e. his personal finance. A trader must be well aware of managing his risk profile before taking his first trade in the market or else he will lose money. If you can’t bear it and don’t want to take risks with your hard-earned money then it’s better to invest with Fixed Income Instruments like FD, PPF etc. Risk management is a very important concept in the risk-reward theory.
Rule of taking Risks in the trade
A 2% rule of risk-reward is very much famous all over the world which states that you should not take a risk of more than 2% of all your investment in a single trade. It is so because it will restrict your losses to 2% when the market turns against your expectations. By doing this, you can continue trading from the next session onwards without suffering heavy losses. Brokerage charges and other related taxes should also form part of that 2% risk only. It is most important in intraday and positional trading as compared to long-term investments.
What is the Need for Risk Reward Ratio
This ratio plays an important role while trading because of the volatility of the stock market. It is generally perceived that you will get only 70% success in the trading which means the chance of hitting the target price in the market is 70 out of 100 and rest 30% chance of risk or unsuccessful trade always remains there.
This scope of loss persists even after you made a trade after completing a technical analysis of the stock. But if you are stepping into a trade without the analysis then the chances of losses in particular trade and making unsuccessful trades will widen to more than 30%. So there are 30% chances that technical analysis fails and when it happens, this risk-reward ratio comes to your help for the protection of your investment.
Risk Reward Ratio Rule
There is one famous Risk Reward Ratio rule of 1:3 that means in a single trade if your stop-loss is 1, then your target must be 3 times that of stop-loss. Stop-loss is a tool to minimize loss and is discussed in another article. For example, you took a trade of 1000 Rs and if your stop-loss is 100 Rs then your target must be 300 (3 times the stop loss). So in this case your stop-loss trigger price must be 900 while your target must be at least 1300. Also, you can be more advanced in placing stop-loss if the market is behaving as per you and you can make use of trailing stop-loss.
Importance of Risk Reward Ratio
The Risk Reward Ratio is important to maintain and it has a very important rule of 1:3. This Risk Reward Ratio rule is very important because it caters for all the expenses and failures of technical analysis while keeping the profit of the trader supreme in its calculations. It is important because it works out best to provide profitable investment when there is a 30% chance of failure for trades.
Suppose we keep our Risk Reward Ratio as 1:1, and 3 out of 10 trades fail (30% unsuccessful trade chances). Then the loss of these 3 unsuccessful trades will be covered by the other 3 successful trades. Now you will be left with only 4 successful trades and the profit of 2 trades among those 4 trades will be consumed by the brokerage and other charges. So, ultimately a trader will be left with NO profit.
And if you keep the Risk Reward Ratio of 1:2, in that case, the loss of these 3 unsuccessful trades (30% unsuccessful trade chances) will be covered by 2 successful trades with other charges also present. So in this case also, the profit margin usually remains very less for a trader.
Nut if we keep the Risk Reward Ratio as 1:3 then the loss of these 3 unsuccessful trades will be covered by only one successful trade and the rest 6 trades will be profitable only. Among those 6 trades, one trade will cover all other charges but ultimately a trader will be left with 5 successful trades. So by keeping a Risk Reward Ratio of 1:3, traders will earn profit in longer durations.
How to Calculate Risk Reward Ratio
Before calculating the Risk-Reward Ratio, you must know both the Risk and Reward levels for your trade. Both these levels are set by the trader himself only.
Risk is the total expected loss that a trader can bear in a particular trade and it is calculated by the stop-loss price. So, Risk is the difference between the stock Buying or Entry price and stop-loss price. Whereas, the Reward is the total expected return or profit anticipated by the trader in a particular trade. The reward is materialized only when the stock or security is sold. It is calculated by the Selling price of the stock and hence, it is the difference between the Selling Price and Entry or Buying Price.
Now, the risk-reward ratio is calculated by dividing the risk by the reward. If this ratio is greater than one then the Risk in that particular trade is greater, while if the ratio is less than one that means that trade is profitable. But the ratio works well only when you apply stop loss and stock hits the target price.
Risk Reward Ratio = Entry Price – Stop loss Price / Selling Price – Entry Price
For example, you bought a stock at a price level of 1000 and applied to stop loss at 900 and your target price is 1500. In that case, your risk-reward ratio will be:
1000 – 900 / 1500 – 1000 = 100/500 = 0.2
Provided the stock hit your target price.
Limitation of Risk Reward Ratio
Risk Reward Ratio is important to mitigate the risk of occurring losses, but it also has its limitation. It does not indicate everything about a trade to you, and you should know the probability of the stock hitting the target as well. If the stock does not meet the target price, then this ratio will not deliver fruitful results to you.
It is possible that traders can stick to a common ratio and keep on applying stop loss based on the entry-level without analyzing the value of the stock. Prevailing market behaviour plays an important role in deciding whether that stock will hit the target or not. So as a trader, you must keep these things in mind while entering the market and using this risk-reward ratio.
You must have heard that many traders lost their money in single or limited trades only after earning beautifully in the stock market only. Because either they forget the importance of this Risk Reward Rule or they ignored the placement of stop-loss while trading.