Risk/reward ratio: why the index is so important for traders?
The appropriate risk/reward ratio calculation helps traders to build their strategies effectively. Learn how to measure risk vs reward and why the index is of much account.
How to calculate the risk/reward ratio professionally?
All investments are linked to certain risks. That is a statement, newcomers should understand forever. Meanwhile, the list of available investment instruments is quite broad, and a person faces a dilemma, whether to select fewer risks or more rewards. The financial experts highlight that risks and rewards are interdependent, and an investor needs to calculate the ratio to make the final decision.
What is the risk/reward ratio?
The risk/reward ratio is an index used by professional investors to compare risks an instrument carries with expected profits. Traders mostly apply to such an index to work out a certain strategy. The interdependence of risk vs reward shows how much profit a trader expects to obtain compared to how much funds they are ready to lose.
The day trading process implies rapid opening and closing deals, using the pros of short-term patterns and trade signals. This strategy includes stop-losses in most cases. Stop-loss orders define the acceptable threshold of risks traders are ready to carry, no matter what kind of asset is purchased or sold.
For instance, a trader purchases Ethereum coins by $342 per one ETH. The acceptable risk threshold is determined at $330 per coin. A trader is ready to lose $12. Meanwhile, the market analysis and technical instruments show the price is about to reach $370 per one ETH coin. The expected profit equals to $28 from 1 ETH.
The risk/reward ratio formula shows the index is 0.42 (12/28). In other words, the potential risk is 42% of the expected reward.
The art of looking for the golden middle?
What is better: low risks or high potential reward? Day traders are expected to find the golden middle. What is a good risk/reward ratio? The ratio is correlated with the deal’s profitability index.
1. High deal’s profitability index shows a trader is able to decrease the risk/reward ratio to get more profits. For instance, a trader’s strategy is profitable when the interdependence of risks and rewards is 1.0, and the deal’s profitability index is more than 50%.
2. When a trade’s deals are profitable in less than 50% of cases, the risk/reward ratio should be 0.65 or lower; otherwise, a trader will be in the red.
To be in the black, traders need to remember the following formulas:
• Minimal required win rate (index of deals profitability) = 1/ (1 + risk/reward ratio).
• Required RRR index = (1/win rate) – 1.
The following table illustrates the interdependence between win rate and RRR indexes, which makes a trading strategy profitable:
Which are the most effective trading indexes?
Day trading strategies imply deals made under diverse market conditions. Successful traders get profits out of 50-70% of all deals. Such an index is regarded as high, and further improving becomes a hard task. On the other hand, traders are accessible to do experiments with risk/reward ratio options.
The above-mentioned profitability index opens more options for a trader. Keeping the risk/ratio index at 1.0 is enough to get profits, while the experts recommend dropping the index to 0.6-0.7.
Myths connected with the index
While newcomer traders are interested in how to calculate risk/reward ratio, there are crowds of ‘experts’ crying the ratio is useless. What are the top myths connected with the index, and why traders should take it into account?
Myth 1. The interdependence between risks and possible rewards makes no sense
A risk/reward ratio indicator is useless without any other methods and instruments, but experienced traders apply to that index to control the profitability of their deals. New entries who neglect the ratio, cannot build up their strategies appropriately, having no comprehension of which measures should be taken to change the situation.
Myth 2. There are some profitable ratio indexes
Some pseudo-experts insist on the existence of certain risk/reward ratio indexes that make the trading process profitable automatically. The ‘specialists’ name 2.0, 3.0, or other indexes, but all these opinions are false. The notion of the most profitable RRR index is quite controversial, as the efficient ratio depends on the chosen strategy and percentage of profitable deals.
Myth 3. The more risk/reward ratio is, the more profit a trader expects to obtain
Inexperienced traders are convinced that a take-profit level increasing or stop-loss index tumbling leads to more profits. The technical analysis instruments show potential price growth; hence, traders should not set take-profits higher. On the other hand, professional traders avoid untimely stop-losses. New entries explain unprofitable deals by the ‘risk management’, while the whole way is entirely wrong.
A step-by-step guide on how to use the RRR index to make a deal
The effective implementation of the risk/reward ratio includes the following steps:
• A trader enters a deal. You need to calculate reward to risk ratio first, to understand which win rate is required by a certain RRR index. When your percentage of successful deals is higher, make a deal.
• When the price moves towards a take-profit level, change a stop-loss threshold to protect your profit. Keep a RRR index within affordable values.
Useful tips for traders
There are some useful tips connected with the risk/reward ratio:
1. A RRR index determines your long-term profitability; hence, experienced traders base their strategies upon this ratio.
2. The risk/reward ratio is the key principle of risk management. Traders, neglecting risk management, are constantly in the red.
3. The ratio can be combined with different graphic instruments (for instance, the Fibonacci correction instrument).
This index is frequently underestimated by newcomer traders, and the experts name this mistake among the key ones of beginners.