A human brain is automatically programmed to find out ways to minimize pain and losses. Whether it’s our daily ordinary activities or trading in financial markets, we somehow figure out practices to avoid pain.
In the financial trading world, be it conventional stock markets or new-age cryptocurrencies, we have a term called risk reward ratio, which helps you in specifying your risk potential in return for a potential reward.
The “risk-reward ratio” in financial markets, is an excellent tool to help you minimize your mental hurt, by providing you with command over your financial losses. And it’s as powerful as it sounds if done in the right way.
Veteran traders and investors always calculate the risk-reward ratio before initiating a trade. Of course, that’s not the singular tool they utilize, but one of the several tools.
But here’s a catch. The tiny three-word term “risk-reward ratio” possesses profundity as of an ocean, and as you dive in-depth, you become better and more efficacious at it. In simple words, the more you discover and practice it, the more you excel in extracting remarkable profits from your financial investments.
Now that it’s clear that calculating the risk-reward ratio before a trade can boost our profits significantly, let’s dive deeper in understanding what the risk-reward ratio is, and how you can use it to increase your profits.
What is the risk-reward ratio?
Let’s say you’re buying a crypto asset at a price of ₹10 and you’re foreseeing the price would rise to ₹20.
But what if the price drops?
To prevent the risk aspect, you instigate a stop loss order at ₹5, when the price hits ₹5, your position will be automatically squared off.
In the above example, you were prepared to risk ₹5 to earn the likely profit of ₹10, and you get your risk-to-reward ratio as 1:2, by simply dividing the risk potential by potential profit.
The risk-reward ratio also known as the R/R ratio, helps you define your prospect gains concerning potential loss.
If someone proposes to you ₹10,000 to go and do something illegal, then the potential loss is that you would end up in jail, and the potential gain is ₹10,000. Is that an intelligent trade? No!
Because the potential loss is much higher than the profit. So, in this case, you dodge making this trade.
As demonstrated in the above example, the risk-reward ratio assists you in sidestepping unhealthy trades. In a nutshell, trades that have a higher risk value than profit are presumed to be avoided.
How to calculate the risk-reward ratio?
The risk-reward ratio defines the relation between profit and loss. Before calculating the risk-reward ratio, you need to assign your profit and loss targets.
The calculation is extremely simple and let’s make it simplest through an example.
Your entry point of the trade is ₹10, your stop loss target is ₹5 and your profit target is ₹20.
Now here’s the formula, (entry point – stop loss) divided by (profit target – entry point)
Which is, (10 – 5) / (20-10)
(5) / (10)
1/2= 1:2
0.5
If your risk reward ratio is below 1.0 then it’s a good trade. In the above example, it’s 0.5, which is a promising indicator. And It is advisable to make trades with a lower risk-reward ratio.
Your task doesn’t conclude with calculating the risk-reward ratio to perform a trade. There are a few more points that you must evaluate to maximize the odds of profitability.
What to consider in risk reward ratio?
Crypto markets are fierce and secretive, it never brags about the direction it’s going to choose. Even an expert trader can predict the move, but can never be foolproof about it. Nobody truly knows the direction it’s going to choose.
Nonetheless, we somehow find out ways to reach the closest to our desire, and the risk-reward ratio is the prime illustration of you reaching the closest to earning profits.
Before you make profits, you require an understanding to effectively set your targets to calculate the risk-reward ratio of your trade. And here’s how you do it.
To calculate the risk-reward ratio, you need to establish a target for both profit and loss. Your anticipated profit, and your loss-bearing threshold. However, designating a target for profit and loss is the tricky part, and a lot of people disarray it up here.
If you’re initiating a trade and you execute a stop loss order at ₹8, then due to flickering prices, the likelihoods are high that it would catch up with your stop loss target and you’ll be at a loss of ₹2.
And how about you implement the stop loss order at ₹5 instead of ₹8, you just minimize the chances of losing money.
But regardless of this example, in a real trade situation, you must go through the technical analysis and fundamentals to indicate the price movements and spirit of the market.
Based on your analysis, decide on a target to place a stop loss order, evaluate your risk potential and determine a practical target for your profit. Never pick a random target as a stop loss or a profit target. Remember, minimizing the mental hurt? If yes, then calculate the risk-return ratio, with your analysis and then choose it wisely.
Wrapping up
Crypto markets are an incredible source to earn financial freedom. Meanwhile, we need to assess the risk element too. People who maintain specialization with their analysis and strategies manage to make profits in markets.
While putting together a trade consider that no analogy or a tool can assure you of the movement of financial markets. It’s always a prediction.
Use your technical analysis and bypass arbitrary numbers to calculate the risk-reward ratio. Stick to your targets and know how much you can lose.
Rest, use your superpower as a human being, the trade with a higher risk ratio than reward can also make you money and vice versa. In a nutshell, be a human and not a system.
