This guide breaks down the basic elements of risk/reward ratios and how to calculate a ratio to improve your investment odds.
The short version
- A risk/reward ratio tells investors how much return they can get on their investment in relation to the risk taken on.
- Any investment with a ratio above 1:3 is considered very risky.
- The risk/reward ratio is calculated by dividing the difference between the stop-loss order and the entry point by the difference between the profit target and the entry point.
What is the risk/reward ratio?
The risk/reward ratio is a factor investors consider when choosing which investments to put their money into. This ratio marks the expected return for any sort of investment.
The risk/reward ratio is calculated by dividing the amount an investor could lose if the price of the asset unexpectedly moves by the amount of profit expected to be made when the deal is over.
For example, let's say you’re thinking about investing in an asset and it has a ratio of 1:5. That means that for every dollar you put into the investment, you can expect to make $5.
Essentially, the ratio helps investors compare the potential profit of a trade to a potential loss.
This same type of ratio is used in betting. In Las Vegas, for example, it's popular to put money down on your favorite NFL team or boxer before a big match. Oftentimes, you'll learn the risk/reward ratio before putting any money down to help you make an educated decision.
What should I look for in a risk/reward ratio?
Any investment greater than a 1:3 ratio is considered risky. At the same time, it can potentially make you very rich. This is a prime example of the phrase “no risk, no reward.”
When looking at a risk/reward ratio, it is essential to take into account how much you are willing to lose for the chance of earning more.
A 1:20 ratio, for example, could potentially take your $1,000 investment and turn it into $20,000. While this potential sounds great, the chances of that actually happening are pretty small. Since the risk that you are taking is so large on the investment, you need to be prepared to see your original $1,000 disappear as well.
Important terms for understanding risk/reward ratios
There are a few important terms you should keep in mind when calculating the risk/reward ratio:
- Stop-loss order: This sets how low an investor will go before selling. A stop-loss order automatically withdraws any funds once a given investment hits that level. This order is designed to help minimize loss by getting out of the trade before the trade value drops even lower.
- Profit target: This is the target or goal that a trade has the potential to reach. The profit target is typically a set exit point for investors.
- Entry point: This is where the unit point of sale begins.
How do you calculate the risk/reward ratio?
Finding out the risk/reward ratio requires a bit of research and math. These numbers are not chosen out of thin air but instead are calculated based on the following criteria:
Determine risk
The first step in calculating this ratio is to determine the risk, which is done by comparing the stop-loss order and the entry point in a trade. The risk is the difference between the two and can be described as the total amount that can be lost.
Determine reward
To determine the potential reward in an investment, traders must consider the total potential profit. This number is set by the profit target and the reward is the total amount of money that you can earn from a trade. It is established by comparing the difference between the profit target and the entry point.
Divide and calculate
The risk/reward ratio is determined by dividing the risk and reward figures. For example, if an investment risk is 23 and its reward is 76, simply divide 23 by 76 to determine the risk/reward ratio. In this example, the risk is 0.3:1.
Here's another example. Let's say you see that stock A is selling for $20, down from a high of $25. You think it will go back up to $25, so you buy $500 worth of stock, or 25 shares. If the stock goes up to $25, then you would make $5 a share, or $125. Since you paid $500 for the shares, you divide 125 by 500, which gives you 0.25. That means your risk/reward ratio is 0.25:1.
Using the risk/reward ratio to determine worthwhile investments
Most investors utilizing this ratio will suggest looking at the ratio and investing based on whether it is above or below 1.0.
In our above example, the ratio is below 1.0 as it is 0:25:1. This means it's less risky. But what if you think that stock A is actually going to increase to $100 a share? Using the calculation above, the risk/reward ratio would be 4:1. It's a big jump from $20 to $100 a share, which means it's a bigger risk.
So if the risk/reward ratio is above 1.0, that means that the potential risk is greater than the potential reward. On the other hand, if the risk/reward ratio is below 1.0, the potential reward is greater than the potential risk.
Most of the time, any investment with a risk/reward ratio between 0.25-1.0 will result in some income. Most day traders will tell you to find investments with a low risk/reward ratio.
Considerations for using the risk/reward ratio
Utilizing this technique is an excellent starting point for any investor. But keep in mind that the ratio won’t tell you everything. When it comes to trading, you also need to be aware of how likely the trade is to reach those targets.
Think of it as a balancing act; the ratio helps you stay on the tightrope, but you need to take the surrounding environment into account to determine how safe an investment actually is.
To help you safely navigate the trading environment, you need a trading plan that takes into consideration things such as market conditions, when and where to enter a trade, and how to determine your stop-loss and profit target under those market conditions.
Doing research — and using tools like stock picking services — can help you make the right call.
The bottom line
There are always potential risks and rewards in investing. The risk/reward ratio can help you decide whether the potential losses and gains are worth making an investment.
This ratio is a tool that is essential for making smart, educated decisions. With a little research and some simple math, you can use the risk/reward ratio to improve your investments.