Risk-Reward Ratio: A Guide for Beginners

Introduction

Whenever you undertake an investment adventure, there is never 100% certainty that you will certainly earn. The chances of winning and losing can depend on the asset you are interested in and the quality of your technical or fundamental analysis. The calculation of risk-reward ratio is very helpful in making your trade a success. Risk-reward ratio refers to the proportion of risk you are ready to take for the reward you expect to earn. The higher the ratio, the riskier your trade is.

Risk-Reward Ratio Explained

Suppose you are trading cryptocurrencies, and you observe that since $BTC is far more expensive than altcoins, you should opt for the latter option. You analyze that if you invest $1000 in $BTC, which is trading at $118,000, you need $BTC to reach $236,000 to double your investment. On the other hand, you think that a low cap altcoin can do 10X more easily. However, you are not taking into account the downside of the coins. If $BTC dominance remains stable or climbs up, even a minor correction in $BTC price can wreak havoc with your altcoin, which can fall 20X. You did consider the reward but ignored the risk.

The Process of Calculation

Calculating the risk-reward ratio is quite straightforward. You need to divide your stop-loss point by the take-profit point.

Risk-reward ratio = Loss %age / Profit %age

You are required to do a proper technical analysis and find the next immediate support or resistance. For example, you open a long position on $LINK which is trading at $18. Your study of the 1D chart reveals that the next resistance lies at $21. You put a TP order there. You analyze that the immediate support is there at $17.25, which has already been tested twice, so it has got slightly weak. You decide to put your SL at $17.25. Although the upside potential is clearly better than the downside risk, the exact risk-reward ratio is still to be determined.

Risk-reward ratio= 4.17% / 16.67% = 1:4 = 0.25

Simply put, for every $1 you are likely to lose, you are likely to earn $4. If you invest $1000, your maximum loss will be $41.1 and maximum profit will be $166.7.

It is indispensable to calculate risk-reward ration based on proper technical analysis. Arbitrary calculations can cost you a big chunk of your investment.

Suppose you place an SL order at a price that is not a support level at any time frame. The price might hit your SL and soar back to reach where you had placed your TP. Your trade is likely to be invalidated where it should not have been if you had done proper technical analysis. While opening your position, it may seem tempting to put your SL close to entry point as it makes the risk-reward ratio very attractive. But as is explained, it can not only deprive you of a good profit, but it can also make you lose money for nothing.

Reward-Risk Ratio

There are few traders who find it easier to understand if they reverse the process of calculating risk-reward ratio.

Reward/risk ration = profit %age / loss %age

Taking the example of the same $LINK trade, let’s calculate the reward-risk ratio.

Reward-risk ratio= 16.67% / 4.17% = 4:1 = 4

The lower number is better when you consider risk-reward ration. In contrast, the higher number is better when you consider reward-risk ratio.

Risk-Reward Ratio + Win-Loss Ratio

When you complete your technical analysis and determine the risk-reward ratio precisely, it is worthwhile to find out your success ratio. The win-loss ratio in your trades is as important as the ratio in the crypto coin you want to trade. For instance, if $LINK trades have win-loss ratio of 25% the risk-reward ratio of 1:4 will take you only to the breakeven point. You need to find an asset either with the win-loss ratio of more than 25% or with the risk-reward ratio of above 1:4. Although it is a bonus when we talk about the tricks up your sleeve, it is not as reliable as it looks because 25% success ratio does not guarantee that you will hit as many TPs as indicated. Therefore, caution must be exercised in following this indicator blindly.

The Benefit of Calculating Risk-Reward Ratio

Sometimes a spot trade looks very attractive because a coin is trading far below its previous all-time high. The risk-reward ratio calculated after proper technical analysis may reveal that the coin has broken down all supports. Now its potential reward is not the all-time high level. Instead, you can only rely on its next resistance level. If you add more study before opening a position, the data about tokenomics may indicate some major supply unlock in next few days. Even an unlock in the past after the previous all-time high may hamper the coin’s breaking the ATH. In short, the level of your potential reward may change when you do extensive groundwork before opening a position.

The Risk in Following the RRR Blindly

The volatility in the crypto market makes reliance solely on risk-reward ratio a blunder. A trade may look very attractive even after proper technical analysis, but when you trust your analysis and calculation too much, you are inclined to feel no need to rebalance and revisit your TP and SL orders. For example, due to some positive news, the resistance may easily be broken, especially if it has been retested multiple times before. When you close your trade, you may miss the profit you can make very easily. It is wise in such a situation to adjust your TP.

Conclusion

The long and short of the discussion is that proper technical analysis and calculation of your potential reward and risk are very useful in risk management. Risk-reward ratio is calculated through dividing the possible loss by possible reward. There is an alternative way to invert the calculation, which gives you a reward-risk ratio. Despite being a useful tool for a trader, relying on it exclusively can be dangerous as well. News and fundamentals must be added to your trade planning to minimize loss.