How To Use RISK vs. REWARD RatiosHi Traders, Investors and Speculators 📈📉
Ev here. Been trading crypto since 2017 and later got into stocks. I have 3 board exams on financial markets and studied economics from a top tier university for a year. Daytime job - Math Teacher. 👩🏫
For today's post, we're diving into the concept " risk reward ratio " by taking a look at practical examples and including other relevant scenarios of managing your risk. What is considered a good risk to reward ratio and where can you see it ? This applies to all markets, and during these volatile times it is an excellent idea to take a good look at your strategy and refine your risk management. Let's jump right in !
You've all noticed the really helpful " long setup " or " short setup " on TradingView chart ideas. This clearly identifies the area of profit (in green), the area for a stop-loss (in red) and your entry (the borderline). It also shows the percentage of your increases or decreases at the top and bottom. This is achieved by using the tool you can find in your toolbar on the left, 7th from the top. The first two options are Long Position and Short Position. It looks like this :
💭Something to remember; It is entirely up to you where you decided to take profit and where you decide to put your stop loss. The IDEAL anticipated targets are given, but the price may not necessarily reach these points. You have that entire zone to choose from and you can even have two or three take profits points in a position.
Now, what is the Risk Reward Ratio expressed in the center as a number.number ?
The risk to reward ration is exactly as the word says : The amount you risk for the amount you could potentially gain. NOTE that your risk is indefinite, but your gains are not guaranteed . The risk/reward ratio measures the difference between the entry point to a stop-loss and a sell or take-profit point. Comparing these two provides the ratio of profit to loss, or reward to risk.
For example, if you're a gambler and you've played roulette, you know that the only way to win 10 chips is to risk 5 chips. Your risk here is expressed as 5:10 or 5.10 .You can spread these 5 chips out any way you like, but the goal of the risk is for a reward that is bigger than your initial investment. However, you could also lose your 5 and this will mean that you need to risk double as much in your next play to make up for your loss. Trading is no different, (except there is method to the madness other than sheer luck...)
Most market strategists and speculators agree that the ideal risk/reward ratio for their investments should not be less than 1:3, or three units of expected return for every one unit of additional risk.
Take a look at this example: Here, you're risking the same amount that you could potentially gain. The Risk Reward ratio is 1, assuming you follow the exact prices for entry, TP and SL.
Can you see why this is not an ideal setup? If your risk/reward ratio is 1, it means you might as well not participate in the trade since your reward is the same as your risk. This is not an ideal trade setup. An ideal trade setup is a scenario where you can AT LEAST win 3x as much as what you are risking. For example:
Note that here, my ratio is now the ideal 2.59 (rounded off to 2.6 and then simplified it becomes 1:3). If you're wondering how I got to 1:3, I just divided 2.6 by 2, giving me 1 and 3.
Another way to express this visually:
If you are setting up your own trade, you can decide at what point you feel comfortable to set your stop loss. For example, you may feel that if the price drops by more than 10%, that's where you'll exit and try another trade. Or, you could decide that you'll take the odds and set your stop loss so that it only triggers if the price drops by 15%. The latter will naturally mean you are trading at higher risk because your risk of losing is much more. Seasoned analysts agree that you shouldn't have a value smaller than 5% for your stop loss, because this type of price action occurs often during a day. For crypto, I would say 10% because we all know that crypto markets are much more volatile than stock markets and even more so than commodity markets like Gold and Silver, which are the most stable.
Remember that your Risk/Reward ratio forms an important part of your trading strategy, which is only one of the steps in your risk management program. There are many more things to consider when thinking about risk management, but we'll dive into those in another post.
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