What Is Risk/Reward Ratio ? | What You Need To Know (2024)

Every trader, no matter their experience, has to deal with risk, which is defined as the potential to lose the whole or part of any funds originally invested. Levels of risk vary on the asset and level of exposure.

There are several types of risk, including market risk, financial risk, credit risk, asset-backed risk, liquidity risk, and systemic and unsystematic risk. Often, a number of these risks can occur at the same time.

So how might a trader manage risk to improve their chances of making positive returns in a market that often goes the opposite way?

Why is trading risk management important?

Risk management is important because trading is already a highly volatile practice, made riskier by the use of leverage, which can amplify both returns and losses. A large majority of traders lose money, so it is important to have mechanisms in place to mitigate losses and try to keep returns more consistent.

Without mitigation strategies, a trader can’t possibly know which risks they are exposed to. It is important to put preventative measures in place. Learning how to manage risk in trading is essential for traders.

What is the risk reward ratio and how can it help in risk management?

A risk reward ratio in trading can be a useful barometer for a trader’s risk appetite, providing some perspective on any potential gains and losses, based on historical data. Note that past performance does not guarantee future returns. A risk reward ratio formula involves dividing potential losses by potential profits, based on predetermined exit orders.

Risk reward ratios are often close to 1.0, as assets that go up by a certain amount also have the same chance of going down by a similar level. Traders can manipulate this ratio by changing the limits at which they take profits and cut their losses.

Consider this risk reward ratio example. After careful analysis a trader decides that shares of Company A that currently trade at £1 will soon go up to £1.10. The trader sets up a take-profit order at £1.10 so that, according to their estimation, they could earn £0.10 a share.

They buy 100 shares, with the potential reward of £10 (£0.10 multiplied by 100). The total amount risked is £100. That’s a high ratio of 0.1 : 1 – not something many traders would accept.

However, some traders would set a minimum price point at which they are willing to close their position through a stop-loss, either guaranteed or ordinary.

Let’s say they set a stop-loss at £0.90, which means they could lose 10p on each share bought for £1 before the stop-loss order is triggered and their position closed. Their risk-reward ratio is now 1:1.

Note that in some market conditions, ordinary stop-losses can be triggered outside the predetermined price. Guaranteed stop-losses, on the other hand, give increased protection, but come at a fee.

There are ways that traders can manage the risk-reward ratio, including observing R-multiples, win rates and screening rates, as well as setting stop-loss and take-profit orders.

Industry professionals often cite 2:1 as the optimal risk-reward ratio for beginners. That would work, for example, by setting a take-profit order at twice the value of the stop-loss. This could be used alongside other risk-management strategies. For example, the ratio could be evaluated alongside the win-loss ratio.

R-multiple in trading

Similar to the risk reward ratio, the R-multiple measures the level of risk in a potential trade.

The ‘R’ stands for risk. The R-multiple symbolises the level of risk, or losses, a trader is prepared to take before exiting their position. A predefined risk reward ratio typically tells a trader when it is not worth taking further losses.

In other words, the R-multiple is the amount a trader risked or lost compared with their initial deposit. An example from the Van Tharp Institute shows an R-multiple analysis in action:

“If you purchased that stock at $50 with the initial stop price of $47 and exited at $47, then you have a -1R trade. You lost what you risked - $3. If, however, the stock went up and you exited at $56, then you had a +2R trade because you earned twice what you risked ($56 - $50 = $6, $6 ÷ $3 = 2).”

Traders would generally want their R-multiple losses to lie between 0 and -1, according to the institute, but they might go beyond this if a trader makes psychological mistakes by failing to get out at their stop-loss point, or if commission costs push their losses beyond the -1 point.

“The principle of cutting your losses short (so you will have small R-multiple losses) and letting your profits run (so you will have big R-multiple gains) is critical for profitable trading,” the report concluded.

What is win rate?

A win rate measures a trader’s number of successful trades relative to their number of unsuccessful trades. Similar to the risk reward ratio, a win rate determines the expected success of a trade.

How do you calculate a win rate? A win/loss ratio is determined by dividing the number of successful trades by losing trades. Anything above 1.0 would be classed as a success. This may help a trader evaluate their trading strategy.

However, win rates alone aren’t necessarily indicative of performance. They could be used alongside other measures such as risk reward to improve traders’ chances of maximising gains and minimising losses.

A potentially effective way to improve a win rate is through screening trades.

Screening involves keeping a track of your performance. It measures a trader’s win rate and risk reward ratio. This can be done through an excel spreadsheet or through automated software that racks performance.

Traders can adjust their portfolios based on these measures, and refine their strategy accordingly.

Stop-losses and take-profit orders

Underpinning all these risk management strategies are mechanisms in place to automatically exit a trade. Stop-loss and take-profit points are predetermined price parameters an investor inputs into an order position, in order to adhere to predefined strategies such as risk reward.

Note that under extreme market conditions such as significant volatility a guaranteed stop-loss would offer more protection as ordinary stop-losses may fail to get triggered at the predetermined level. Guaranteed stop-losses are chargeable.

Risk management requires discipline, notably on the take-profit side. Traders may be tempted to raise their profit limit each time a trade hits that point. But at some point, the ceiling will be too high, meaning a trader misses a point of profitability and is forced to fall back to their stop-loss point.

Ultimately, trading is a risky activity and requires thorough research. But strategies based on sto- loss and take-profit orders, which help evaluate their effectiveness, can potentially give traders a better chance of improving their average outcomes.

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