Risk ratio / risk reward ratio
What is the risk/reward ratio?
The risk-reward ratio is the measure used by investors during trading to know their potential loss versus the potential profit from trading and then used by traders to effectively manage their risk and capital during the trading process. this, therefore, implies that the investor is willing to risk Rs1 for a potential gain of Rs4
Risk ratio, also called relative risk, can be defined as a metric used to measure the risk taken in a given group and compare the results obtained by that group with the results of measuring a similar risk in another group.
Explanation
The risk-reward ratio in trading is determined by dividing the expected gains involved in trading by the potential risk two factors are important in determining this ratio i.e. risk and reward where risk refers to the potential for loss of the money invested by the trading investors and the Premium refers to the Premium expected by the investor to take the potential risk of losing the money invested.
These factors are judged or estimated by the investor himself, as they depend on the investor’scapacity for risk tolerance. If the calculated ratio is greater than 1, then this indicates that the risk of the transaction is greater than the expected profits, and if the calculated ratio is less than 1, then it indicates that the risk of the transaction is less than the expected profits.
Risk-reward formula
To calculate the risk-reward ratio, the investor must first determine the risk involved in the transaction. After determining the risk, he needs to determine the expected benefits that he will get after dealing with the potential risk of losing his invested money.
Finally, after determining the potential risk and expected rewards, the risk-reward ratio will be calculated by dividing the potential risk by the expected rewards in trading. The formula is:
Risk–Reward Ratio = Potential Risk in Trading / Expected Rewards
The ratio is taken into account by investors when trading the stock because it helps them assess their expected return
as well as the risk associated with that trade. The relationship varies from one strategy to another, that is, this relationship does not stay the same and differs depending on the strategy adopted by the person.
Therefore, to calculate the risk-reward ratio, the expected return and the associated risk must be judged by the trader himself. The risk is known mainly based on the stop loss order, i.e. the risk will be calculated by calculating the difference between the value of the stop loss order and the value at which the trade is entered by the investor, and the expected return is calculated by calculating the difference between the value of the stop loss order and the trader’s profit target.
Importance
The risk/reward ratio helps the trader to manage the potential risk of losing the money he has invested.
It gives the investor an idea of the expected return that he could generate with a given level of risk and, therefore, the decision can be made. Hence, it will help the investor to make the decision based on his risk-taking ability.
Conclusion
The risk-reward ratio provides a measure of the expected benefits that the investor will generate with a given level of potential risk. This report is very useful for investors when making decisions about their business investment. Thus, the investment will be made by the investor according to his capacities on the basis of this ratio
