Risk / Reward Calculator
The risk/reward ratio is an essential financial risk calculator that determines the investment worthiness of any asset. In simple terms, it tells how much return you can get in relation to the risk you take by investing in the asset.
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. 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. The ratio helps investors compare the potential profit of a trade to a potential loss.
While the acceptable ratio can vary, trade advisers and other professionals often recommend a ratio between 1-to-2 and 1-to-3 to determine a worthy investment.
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 to Calculate Risk / Reward Ratio?
While there is a formula for calculating the Risk to Reward ratio, there are certain factors that need to be accounted for before calculating:
- Determine risk – The first step in calculating the risk-reward ratio is to determine the risk. This 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 – The next step is to determine the potential reward in an investment. This means 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 – Finally, the risk/reward ratio is determined by dividing the risk and reward figures.
The Formula for Calculating Risk to Reward
Risk Reward Ratio = (Take Profit Price – Entry Price) / (Entry Price – Stop Loss Price)
Here is an example of calculating the risk-reward ratio. You bought a stock for $ 100. You plan to sell it when it hits $ 200 to earn a profit of $100. If you are willing to risk the entire investment, then the value of your risk is $ 100. So, 100 divided by 100 is 100/100 or 1-to-1. The risk and reward are equal.
Now consider the same investment with a stop-loss at $ 50 but with the same expected profit of $100. You are willing to risk $ 50 to make double that. That’s 50 for the risk, 100 for the reward, or 50/100, which is .5-to-1. However, risk is typically represented as 1 in the risk-reward ratio, so .5-to-1 is expressed as 1-to-2.
Who Uses the Risk / Reward Ratio?
The risk-reward ratio is most commonly used by stock traders, investors, and others in financial services to evaluate financial investments such as stock purchases. They sometimes limit risk by issuing stop-loss orders, which trigger automatic sales of stock or other securities when they hit a specific value. Without such a mechanism in place, risk is potentially unlimited, which renders the risk-reward ratio incalculable.
The ratio is also used by project managers. They use it to quantify the potential risks and benefits of a project. Project leaders use the ratio to assess the feasibility of the project as a whole, as well as for assessing specific components of the project.
The risk-reward ratio is also used to compare investments. A project that has the same expected return as another project but has less risk is usually deemed the better choice.
Benefits and Limitations of Using Risk/Reward Ratio
The risk-reward ratio helps investors with risk management by doing the following:
- This ratio helps manage risks by evaluating and expressing the potential risks.
- This ratio helps objectively evaluate risks and rewards. It’s a mathematical ratio that removes all subjectivity from the analysis.
- This ratio enables investors to quickly calculate and reevaluate all risks and rewards when the circumstances change.
The following are some drawbacks of the risk-reward calculation:
- It does not consider probability.
- The ratio is dependent upon the quality of the investor’s research and ability to gauge risk.
- The risk-reward ratio does not incorporate other potential factors and calculations. These include factors like stock market fluctuations and volatility. The risk/reward ratio is not always accurate; the investor must make a decision based on their risk appetite and price movement expectations.
So while the risk-reward ratio can help calculate and compare investment risks, the figure in and of itself is not considered adequate for determining worthwhile investments.
How to Make an Informed Decision With a Risk / Reward Ratio?
Risk-to-Reward ratio is one of the most important ratios to consider for traders and investors.
After determining the Risk-reward ratio for a trade, you can place a stop-loss order to limit your losses. Similarly, you can use the book profit order to exit the position at the price you want.
If the risk/reward ratio is greater than 1.0, the potential risk outweighs the potential reward. If the risk/reward ratio is less than 1.0, the potential reward is greater than the potential risk. Generally, any investment with a risk/reward ratio of 0.25-1.0 will generate some income. The majority of day traders will advise you to look for investments with a low risk/reward ratio.
Most beginners tend to have very poor risk profiles and they tend to settle with a risk-reward ratio of 1.2 or 1.5 which is not a good ratio. Try to aim for a better ratio of at least 2 or more. Typically, a win-loss ratio of more than 2 is always good since it lets you have a win rate of only 50% to break even.
Also, only reassess your risk-reward ratio if your trade plan or setup has changed. If your plan stays the same, stick with the same calculations.