RISK : REWARD. Visualized breakdown
⚠️Regardless of whether you prefer day trading or swing trading, you need to understand the fundamental concepts regarding risk. They form the basis of understanding the market, managing trading activities, and investment decisions. Otherwise, you will not be able to protect and increase your balance.
We have already discussed risk management, position size, and stop-loss setting. But if you are actively trading, answer two important questions. How does the growth potential relate to potential losses? In other words, what is your risk-reward ratio?
In this article, we will discuss how to calculate the risk-to-profit ratio for any transaction.
✅What is the ratio of risk and profit?
🟢The risk-reward ratio (risk/reward or R/R ratio) allows you to understand what risk a trader is taking for the sake of a potential reward. In other words, it shows what the potential profit is for every dollar you risk when investing.
🟢The calculation itself is very simple. The maximum risk is divided by the net target profit. How exactly? First, think about where you want to enter into the transaction. Decide where you will take profit (if the trade is successful) and where to place a stop loss (if it is a losing trade). This is extremely important for effective risk management. Good traders set profit targets and stop-loss before entering a trade.
Now you have entry and exit points, that is, you can calculate the ratio of risk and profit. To do this, you need to divide the potential risk by the potential profit. The lower this coefficient is, the more potential profit you will receive per "unit" of risk. Let's figure out how it works.
✅How to calculate the ratio of risk and profit
🟢Let's say you want to open a long position on bitcoin. You perform an analysis and determine that your take profit order will be 15% of the entry price. Next, you have to answer the following question: where your position will be closed in case of a market reversal. This is where you will have to set a stop loss. In this case, you decide that your cancellation point will be 5% of the entry point.
It is worth noting that it, as a rule, should not be based on arbitrary percentage numbers. The profit target and stop loss should be determined based on market analysis. Technical analysis indicators are very useful for solving this problem.
🟢So, our profit target is 15%, and the potential loss is 5%. What is the ratio of risk and profit? 5/15 = 1:3 = 0,33. Everything is simple. This means that for each unit of risk we potentially win three times more. In other words, for every dollar we risk, we can get three dollars. Thus, if we have a position worth $100, then we risk losing $5 with a potential profit of 15.
🟢You can also move the stop loss closer to our entry to reduce this ratio. However, the entry and exit points should not be calculated arbitrarily, but solely based on analysis. If a trading position has a high risk-to-profit ratio, it is probably not worth "arguing" with the numbers and hoping for success. In this case, we recommend choosing another position with a good risk-reward ratio.
‼️Please note: positions with different sizes may have the same risk-to-profit ratio. For example, if we have a position worth $10,000, we risk losing $500 for a potential profit of $1,500 (the ratio is still 1:3). The ratio changes only if we change the relative position of our target and stop loss.
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