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Risk or Reward Ratio Definition
Table of Contents
What is the Risk or Reward Ratio?
This ratio marks the expected reward an investor can earn for every dollar. The risk on an investment. Many investors use this ratios to compare the expected returns of an investment.
With the amount of risk that they must undertake to earn these returns. Consider the following example. An investment with a risk-reward ratio of 1:7 is suggested that an investor is willing to risk $1. For the outlook of earning $7.
Alternatively, a Risk or Reward ratio of 1:3 signals that an investor should expect to invest at $1. For the view of earning $3 on their investment.
Traders frequently use this approach to plan which trades to take. The ratio is calculated by dividing the amount that a trader stands to lose.
If the price of an asset moves in an unexpected direction. The risks by the amount of profit the trader expects to have made. When the position has closed the reward.
How this ratio works?
In many of the cases, market a person skilled in planning action will find the suitable ratio. For their investments to be approximately 1:3.
The three units of expected return for every one unit of additional risk. Investors can manage the risk or reward more directly through the use of stop-loss orders. Also the derivatives like a put option.
This ratio is frequently used as a measure. When trading the individual stocks. The best ratio differs widely among the various trading strategies. Some the trying of one thing methods are usually required to determine.
That which ratio is best for a given trading strategy. Many of the investors have a pre-specified ratio for their investments.
What Does the Risk or Reward Ratio Tell one?
This ratio helps the investors to manage their risk of losing money on trades. Even if a trader has some profitable trades. Then they will lose money over time if their win rate is below 50%.
This ratio measures the difference between a trade entry point to stop-loss. To sell or take-profit order. Comparing these two provides the ratio of profit to loss, or reward to risk.
Investors are frequently used to stop-loss the orders. When trading individual stocks to help to minimize the losses. Directly manage their investments with a risk or reward focus.
A stop-loss order is trading to release placed on a stock that automates the selling of the stock to form a portfolio. If the stock reaches a specified low.
Investors can automatically set the stop-loss orders through the brokerage accounts. They typically do not require unreasonably high additional trading costs.
Example
Consider this example. A trader purchases 100 shares of XYZ Company at the price of $20. He places a stop-loss order at the price of $15 to make sure that losses will not exceed the price of $500.
Also, assume that this trader believes that the price of XYZ will reach up to $30 in the next few months. In this case, the trader is willing to risk the price of $5 per share. To make an expected return of $10 per share after closing the position.
Since the trader stands to make double the amount that they have risked. They would be said to have a 1:2 risk or reward ratio on that particular business.
Arrangement contracts like put contracts, which give their owners the right to sell the underlying asset at a specified price. It can be used to a similar effect.
If an investor prefers to attempt to find a 1:5 risk or reward ratio for a specified investment. The five units of expected return for each additional unit of risk.
Risk or Reward Ratio
Then they can modify the stop-loss order. Thus adjust this ratio. But it is important to understand that by doing so the investors have to change the probability of success in their trade.
In the trading example noted above, suppose an investor set a stop-loss order at the price of $18. Instead of $15, and they continued to target a price of $30 taking a profit exit. By doing so they would certainly reduce the size of the potential loss.
Assuming no change to the number of shares. But they will have to increase the probability that the price action will trigger their stop-loss order. That is because the stop order is the amount to something else.
Much is closer to the entry than the target price is. So although the investor may stand to make a proportionally larger gain. Comparing to the potential loss. They also have a lower probability of receiving this result.
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