Content of the material
Risk Reward Ratio Calculator
Your Risk Per Trade*:
Your buy/sell quantity should be:
You risk per share is:
Your Target according to Risk Reward Ratio should be:
1:1 Risk Reward Ratio Target:
1:2 Risk Reward Ratio Target:
1:3 Risk Reward Ratio Target:
1:4 Risk Reward Ratio Target:
1:5 Risk Reward Ratio Target:
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:
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.
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.
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.
Before we learn if our XYZ trade is a good idea from a risk perspective, what else should we know about this risk/reward ratio? First, although a little bit of behavioral economics finds its way into most investment decisions, risk/reward is completely objective. It’s a calculation and the numbers don’t lie.
Second, each individual has their own tolerance for risk. You may love bungee jumping, but somebody else might have a panic attack just thinking about it.
Next, risk/reward gives you no indication of probability. What if you took your $500 and played the lottery? Risking $500 to gain millions is a much better investment than investing in the stock market from a risk/reward perspective, but a much worse choice in terms of probability.
In the course of holding a stock, the upside number is likely to change as you continue analyzing new information. If the risk/reward becomes unfavorable, don't be afraid to exit the trade. Never find yourself in a situation where the risk/reward ratio isn't in your favor.
Limiting Risk and Stop Losses
Unless you're an inexperienced stock investor, you would never let that $500 go all the way to zero. Your actual risk isn't the entire $500.
Every good investor has a stop-loss or a price on the downside that limits their risk. If you set a $29 sell limit price as the upside, maybe you set $20 as the maximum downside. Once your stop-loss order reaches $20, you sell it and look for the next opportunity.
Because we limited our downside, we can now change our numbers a bit. Your new profit stays the same at $80, but your risk is now only $100 ($5 maximum loss multiplied by the 20 shares that you own), or 80/100 = 0.8:1. This is still not ideal.
What if we raised our stop-loss price to $23, risking only $2 per share or $40 loss in total? Remember, 80/40 is 2:1, which is acceptable. Some investors won't commit their money to any investment that isn't at least 4:1, but 2:1 is considered the minimum by most. Of course, you have to decide for yourself what the acceptable ratio is for you.
Notice that to achieve the risk/reward profile of 2:1, we didn’t change the top number. When you did your research and concluded that the maximum upside was $29, that was based on technical analysis and fundamental research. If we were to change the top number, in order to achieve an acceptable risk/reward, we’re now relying on hope instead of good research.
How the Risk/Reward Ratio Works
In isolation, it is better to take trades that have lower risk/reward ratios. That means the profit potential outweighs the risk. The risk/reward ratio doesn't need to be very low to work, though.
Trades with ratios below 1.0 are likely to produce better results than those with a risk/reward ratio greater than 1.0. For most day traders, risk/reward ratios typically fall between 1.0 and 0.25.
Day traders, swing traders, and investors should shy away from trades where the profit potential is less than what they are putting at risk. This is indicated by a risk/reward greater than 1.0. There are enough favorable opportunities available that there is little reason to take on more risk for less profit.
When figuring out the risk/reward for a trade, place the stop-loss at a logical place. Then, place a logical profit target based on your strategy and analysis. These levels should not be randomly chosen.
When the stop-loss and profit target locations are set, only then can you assess the risk/reward of the trade and decide whether the trade is worth taking.
Sometimes, investors will use a reward/risk ratio instead, which is the reverse of the risk/reward ratio. In this case, you want a ratio greater than 1.0. The higher the number, the better.