The risk/reward ratio measures the potential profit an investment can produce for every dollar of losses the trade poses for an investor.
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How Does the Risk/Reward Ratio Work?
All investing has risk. Whilst investors generally are aiming to make money from their investments, there’s the possibility to lose some or all the money invested as well. The risk/reward ratio is a tool investors are able to use to compare the possible profits and losses of an investment.
The risk/reward ratio works by comparing an investment’s potential losses to its possible profits. If you can calculate the possible risk and reward of a trade, all you must do is divide the risk by the reward to find the ratio. Think of it this way: It’s the profit you can look for on an investment per pound worth of risk involved in a trade.
This makes it possible for the risk/reward ratio to produce an easy insight into whether or not an investment is worthwhile making. This is popular with day traders who want to move in and out of the market quickly as it allows them to choose about how much to risk to generate a potential gain.
How To Calculate Risk/Reward Ratio.
To calculate the risk/reward ratio, use this formula:.
Potential loss/ potential profit = risk/reward ratio.
Some investors use the reward/risk ratio, which reverses the above formula. However, for reward/risk ratios, higher numbers are better for investors.
Investors determine the potential risk and reward of investment by setting profit targets and stop-loss orders. A stop-loss lets you automatically sell a security if it falls to a certain price.
Example of Risk/Reward Ratio.
Let’s say you’re thinking about two different investments: a high-risk, high-reward stock and a low-risk, low-reward bond. The stock has the possibility to increase in value by 50% but also has the possibility to lower in value by 25%. The bond has the capacity to grow in value by 5% but only has the potential to reduce in value by 2%.
If you work out the risk-to-reward ratio for each investment, you’ll get the following:.
High-risk, high-reward stock: 2:1 (50% potential profit divided by 25% potential loss).
Low-risk, low-reward bond: 2.5:1 (5% potential profit divided by 2% potential loss).
In this scenario, the low-risk, low-reward bond actually has a higher risk-to-reward ratio than the high-risk, high-reward stock. This means that the bond is a better investment choice if you’re trying to find a higher potential profit compared to a potential loss.
Another example might be if you’re considering two stocks: one with the possibility to increase in value by $10 per share and the possibility to decrease in value by $5 per share, and another with the potential to increase in value by $5 per share and the potential to decrease in value by $1 per share.
The risk-to-reward ratio for each investment would be as follows:.
First stock: 2:1 ($ 10 potential profit divided by $5 potential loss).
Second stock: 5:1 ($ 5 potential profit divided by $1 potential loss).
In this particular situation, the second stock has a higher risk-to-reward ratio, meaning that it’s a better investment choice if you’re trying to find a higher potential profit compared to a potential loss.
A risk/reward ratio that is less than 1 indicates an investment with greater potential reward than risk. Ratios higher than 1 indicate investments with more risk than the potential reward. A ratio equal to 1 indicates equal risks and rewards.1.
In general, it’s much better to make trades with low risk/reward ratios as that suggests the investments will make more profits than losses.
However, the risk/reward of trade only demonstrates two basic pieces of information: potential gains or losses. It doesn’t indicate anything about the odds of generating either outcome.
Note.
For instance, a $1 lottery ticket with a $1 million jackpot has a risk/reward ratio of 0.000001. This is although that the odds of basically winning the jackpot are extremely low.
For this reason, lots of investors use other tools to account for things like the probability of attaining a certain gain or experiencing a certain loss.
Alternatives to the Risk/Reward Ratio.
Risk/reward ratio is just one tool traders are able to make use of to analyze investment opportunities. Day traders frequently use a different ratio, the win/loss ratio to consider their investments. This ratio measures how many of an investor’s trades turn a profit as opposed to how many generate a loss.
For example, an investor who makes 10 trades, five of which make a profit and five of which lose money, will have a win/loss ratio of 50%.
The higher an investor’s win/loss ratio, the more risk they can accept on individual trades because those trades are most likely to work out, assuming they put in a similar amount of attention and due care when making investing decisions.
Investors with low win/loss ratios should focus on investments with lower risk/reward ratios to ensure that their profits from winning trades exceed the losses from their more frequent unsuccessful trades.2.
Pros and Cons of the Risk/Reward Ratio.
Pros.
Easy to calculate: Risk/reward ratio uses a really simple formula, which means investors can quickly use it to make decisions on the fly.
Assists with risk management: The ratio explains the risk of an investment, giving an investor more information with which to determine whether or not to make a trade.
Cons.
May not be totally accurate: Risk/reward ratios are calculated using potential profits and stop-losses set by the investor. A stock may rise or fall in price too quickly for the investor to sell at the preferred price, meaning actual profit or loss could exceed the theoretical gain or loss.
Does not account for the odds of gains or losses: Risk/reward ratio considers only the potential profit and loss an investment could produce. There’s no space in the calculation to consider the likelihood of either outcome.
The ratio takes a look at binary outcomes without considering stable prices: Stocks can rise or fall in price, but they may also hold firm. Risk/reward ratios fail to consider this opportunity, which is a disadvantage for day traders who want to make regular trades.
What It Means for Investors.
Individual investors can use the risk/reward ratio when taking into consideration whether to make a trade. You may also use the ratio to decide where to put your price targets or stop-loss orders to create a trade that has the risk/reward potential you wish for.
For long-term investors, risk/reward ratio is less valuable because you are more likely to hold shares through a variety of price fluctuations.
