The risk/reward ratio works by comparing an investment’s potential losses to its potential profits. If you can calculate the potential risk and reward of a trade, all you have to do is divide the risk by the reward to find the ratio. Think of it like this: It’s the profit you can expect on an investment per dollar worth of risk involved in a trade. This allows the risk/reward ratio to provide a quick insight into whether an investment is worth making. This is popular with day traders who want to move in and out of the market quickly as it lets them make decisions about how much to risk to generate a potential gain.
How To Calculate Risk/Reward Ratio
To calculate risk/reward ratio, use this formula: Potential loss / potential profit = risk/reward ratio Investors determine the potential risk and reward of an investment by setting profit targets and stop-loss orders. A stop-loss lets you automatically sell a security if it falls to a certain price.
Example of Risk/Reward Ratio
Imagine that XYZ is currently trading at $50 per share. You think it will rise to $60. You buy 100 shares at $50 and set a stop-loss order at $45. In this scenario, your potential profit (reward) is $1,000 ($10 per share multiplied by 100 shares). Your potential losses are equal to $500 ($5 per share multiplied by 100). That would make the risk/reward ratio of this investment $500 / $1,000 = 0.50. In general, it’s better to make trades with low risk/reward ratios because that implies the investments will produce more profits than losses. However, the risk/reward of a trade only shows two basic pieces of information: potential gains or losses. It doesn’t indicate anything about the odds of producing either outcome. For this reason, many investors use other tools to account for things like the likelihood of achieving a certain gain or experiencing a certain loss.
Alternatives to the Risk/Reward Ratio
Risk/reward ratio is just one tool traders can use to analyze investment opportunities. Day traders often use another ratio, the win/loss ratio to think about their investments. This ratio measures how many of an investor’s trades turn a profit compared with how many generate a loss. For example, an investor who makes 10 trades, five of which turn a profit and five of which lose money, will have a win/loss ratio of 50%. The higher an investor’s win/loss ratio, the more risk they can accept on individual trades because those trades are more likely to work out, assuming they put in a similar amount of care and due diligence when making investing decisions. Investors with low win/loss ratios should focus on investments with lower risk/reward ratios to ensure that their profits from winning trades exceed the losses from their more frequent unsuccessful trades.
Pros and Cons of the Risk/Reward Ratio
Pros Explained
Easy to calculate: Risk/reward ratio uses a very simple formula, which means investors can easily use it to make decisions on the fly.Helps with risk management: The ratio describes the risk of an investment, giving an investor more information with which to determine whether to make a trade.
Cons Explained
May not be fully accurate: Risk/reward ratios are determined using potential profits and stop-losses set by the investor. A security could rise or fall in price too quickly for the investor to sell at the desired price, meaning actual profit or loss could exceed the theoretical gain or loss.Does not account for the odds of gains or losses: Risk/reward ratio considers only the potential profit and loss an investment could produce. There’s no space in the calculation to consider the likelihood of either outcome.The ratio looks at binary outcomes without considering stable prices: Securities can rise or fall in price, but they can also hold steady. Risk/reward ratios don’t account for this possibility, which is a drawback for day traders who want to make frequent trades.
What It Means for Individual Investors
Individual investors can use the risk/reward ratio when considering whether to make a trade. You can also use the ratio to make decisions about where to set your price targets or stop-loss orders to create a trade that has the risk/reward potential you desire. For long-term investors, risk/reward ratio is less valuable because you are more likely to hold shares through a series of price fluctuations.
