# Risk/Reward Ratio

## What Is the Risk/Reward Ratio?

The risk/reward ratio denotes the prospective reward an investor can earn for each dollar they risk on an investment. Numerous investors use risk/reward ratios to compare the expected returns of an investment with the amount of risk they must undertake to earn these returns. Think about the following model: an investment with a risk-reward ratio of 1:7 recommends that an investor will risk \$1, for the prospect of earning \$7. On the other hand, a risk/reward ratio of 1:3 signs that an investor ought to hope to invest \$1, for the prospect of earning \$3 on their investment.

Traders frequently utilize this approach to plan which trades to take, and the ratio is calculated by partitioning the amount a trader stands to lose on the off chance that the price of an asset moves in an unexpected heading (the risk) by the amount of profit the trader hopes to have made when the position is closed (the reward).

## How the Risk/Reward Ratio Works

By and large, market strategists track down the best risk/reward ratio for their investments to be around 1:3, or three units of expected return for each one unit of extra risk. Investors can oversee risk/reward all the more straightforwardly using stop-loss orders and derivatives, for example, put options.

The risk/reward ratio is much of the time utilized as a measure while trading individual stocks. The optimal risk/reward ratio contrasts widely among different trading strategies. A few experimentation methods are typically required to figure out which ratio is best for a given trading strategy, and numerous investors have a pre-indicated risk/reward ratio for their investments.

## What Does the Risk/Reward Ratio Tell You?

The risk/reward ratio assists investors with dealing with their risk of losing money on trades. Even on the off chance that a trader has a few profitable trades, they will lose money over the long haul assuming their success rate is below half. The risk/reward ratio measures the difference between a trade entry point to a stop-loss and a sell or take-profit order. Looking at these two gives the ratio of profit to loss, or reward to risk.

Investors frequently use stop-loss orders while trading individual stocks to assist limit losses and straightforwardly deal with their investments with a risk/reward center. A stop-loss order is a trading trigger put on a stock that computerizes the selling of the stock from a portfolio if the stock arrives at a predetermined low. Investors can consequently set stop-loss orders through brokerage accounts and commonly don't need excessive extra trading costs.

## Illustration of the Risk/Reward Ratio being used

Think about this model: A trader purchases 100 shares of XYZ Company at \$20 and places a stop-loss order at \$15 to guarantee that losses won't surpass \$500. Additionally, accept that this trader accepts that the price of XYZ will reach \$30 in the next couple of months. In this case, the trader will risk \$5 per share to make an expected return of \$10 per share in the wake of 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/reward ratio on that specific trade. Derivatives contracts, for example, put contracts, which give their owners the right to sell the underlying asset at a predetermined price, can be utilized to comparative effect.

In the event that an investor likes to look for a 1:5 risk/reward ratio for a predefined investment (five units of expected return for each extra unit of risk), then they can change the stop-loss order and hence change the risk/reward ratio. However, it is important to comprehend that thusly the investors has changed the likelihood of outcome in their trade.

In the trading model noted above, assume an investor set a stop-loss order at \$18, rather than \$15, and they kept on targeting a \$30 profit-taking exit. Thusly they would absolutely reduce the size of the expected loss (accepting no change to the number of shares), yet they will have increased the probability that the price action will trigger their stop loss order. That is on the grounds that the stop order is relatively a lot nearer to the entry than the target price is. So albeit the investor might remain to make a relatively bigger gain (compared to the likely loss), they have a lower likelihood of getting this outcome.

## Features

• A fitting risk reward ratio will in general be anything greater than 1:3.
• The risk/reward ratio is utilized by traders and investors to deal with their capital and risk of loss.
• The ratio surveys the expected return and risk of a given trade.