Risk-to-Reward Ratio: A complete guide to master it
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Risk-to-Reward Ratio: A complete guide to master it

 

INTRODUCTION

The primary motivation and driving force of investment is a reward. However, there is a possibility that actual returns are lower than what is expected due to associated risk; for a matter of fact, it can be due to the low performance of the company, global crises or Pandemic like COVID-19 that we are facing currently. 

“Security is mostly a superstition. It does not exist in nature, nor do the children of men as a whole experience it. Avoiding danger is no safer in the long run than outright exposure. Life is either a daring adventure or nothing.” - Helen Keller

Even Life is not risk-free no matter what, we have to take calculated risks. You can take examples of your own experiences when there might be times when you need to take the less travelled road or say you have to choose between doing a regular job or starting up your own business. There is an amount of risk involved in it. 

Can we eliminate risk? The simple answer is No. We can't eliminate risk from our lives as well as in investment decisions. No investment is free of RISK, and no investment is done without the intention of earning a reward. Thus, risk and reward go hand in hand.

It becomes important to comprehend the relationship between risk and reward to build investment and trading strategies.

 

DEFINITION OF RISK-TO-REWARD RATIO

Let's understand the risk to reward ratio through a hypothetical situation. Suppose you are giving a competitive exam where you need to attempt a question. For every correct answer, you will score 4 and for every wrong answer, you will lose 1 mark. For attempting this question of 4 marks you are willing to take a risk of sacrificing 1 mark. Therefore, the risk-to-reward ratio is 1:4 for attempting that question. Similarly, consider 4 points for the correct answer as Expected return for an investor/trader and 1 point as risk investor/trader is willing to take. 

Thus, the Risk-to-Reward Ratio is used to measure the expected return or a reward for each unit of risk they are willing to take for that particular trade or investment.

The benefit of using this ratio is to manage the capital as well as the portfolio and minimise the risk of losing money. Ideally, 1:3 is considered as a suitable ratio or anything greater than it. But we can't generalise this fact, due to the varying risk appetites of investors and traders. Traders are indifferent towards their entry-exit strategies for trade and may use hit and trial methods to evaluate optimal ratios for them. 

 

USE OF RISK TO REWARD RATIO IN TRADING

Trader uses risk-to-reward ratio to measure the variation between trade entry point to stop loss point which is done to minimise the risk and between trade entry point to target profit to calculate reward prospects.

In simple terms, it is used to measure potential profits by minimising losses through stop-loss orders.

For example: If the trader purchases 200 shares of Rs 20 each, total being Rs 4000. To minimise the loss trader places a stop-loss order at Rs.15 so that the loss didn't exceed Rs.1000. Assuming the share prices go up to Rs. 30, the trader is willing to take a risk of Rs. 5/share with prospects of earning Rs. 10/share.

However, the trader is risking Rs. 1000 (5 X 200) for an expected return of Rs.  2000 (10 X 200). The RRR is coming out to be 1000/2000 or 1:2 for that particular trade.

Note: The ratio is subjective to particular trade due to varying trade strategies used by Traders.

Thus, Traders will lose if the share prices move in an unexpected direction by the amount of expected return if the price moves closer to the expected direction.

 

CALCULATION: RISK To REWARD Ratio

The formula for calculating risk-to-reward ratio (RRR) in trading:

RRR= (ENTRY POINT VALUE - STOP LOSS VALUE)/(TARGET PROFIT - ENTRY POINT VALUE) 

This implies, Risk to be taken / Expected Reward 

 

WORKING OF RATIO

After understanding how traders use the risk-to-reward ratio and its calculation let us now understand the working of the ratio at different stop-loss order points. Assuming entry point and target profit to be constant as Rs. 20/share and Rs. 30/share respectively. The total shares to be traded are 200. 

Consider a situation where a trader is putting a stop loss closer to the entry point. Let's say stop loss at Rs. 19, the ultimate risk will be 1 for a reward of Rs 10 (target profit-entry point). The reward to risk ratio will be 1:10 which means higher the stop loss higher is the chance of minimising potential loss and earning a higher return. But the market is always uncertain and there is a high probability of price to trigger a stop loss as it's quite close to the entry point which will also lead to losing expected return. If we consider another situation where we put a stop-loss point at Rs. 9, the chance of risk increases to Rs. 11 and the reward is Rs. 10 less than the risk. Thus, setting up a lower stop-loss order can increase the chances of higher risk for a lower return. 

 

Note: It's always advisable for traders to set a reasonable stop loss order as well as a logical target profit according to strategies used.

 

LIMITATIONS OF RISK-TO-REWARD RATIO

R/R ratio alone can't be used to establish risk associated with any trade. Another ratio must be taken into consideration like the win/loss ratio or break-even points.

It's difficult to place favourable stop-loss orders and target prices because of the volatile nature of the market.

 

CONCLUSIONS

“Risk comes from not knowing what you’re doing.” - Warren Buffet

Whether you are a good investor or trader you can't escape from the risk associated with any securities. There will be a portion of the investment you may be losing. But by taking calculated risks and assuming realistic returns you can maintain your portfolio. This can be only achieved when you have experience and knowledge about the market. 

 

We, at Cerebro Team, aim to spread financial literacy across India. We have introduced various certificate programmes for stock trading and investment for students as well as professionals.

For further information visit: www.cerebroteam.com

 

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  • Author : Jasleen Gallay

    2021-08-12 16:10:45

    A writing enthusiast.