Risk Reward Ratio

The Risk-to-Reward ratio is used to weigh a trade's potential profit (reward) against its potential loss (risk). A lower ratio is preferable, offering higher returns without excessive risk.
EXPLORE FUNDS
What is Risk Reward Ratio
EXPLORE FUNDS
3 min
19-September-2024
The risk-reward ratio is a measure used in investment to compare the potential return of an investment to the amount of risk taken to achieve that return. It is calculated by dividing the potential loss by the potential gain, providing a metric to evaluate the balance between risk and reward in an investment without undue risk-taking.

In this article, we will explore the significance of the risk-reward ratio in investment strategies, risk-reward ratio meaning, and its implications for investors. We will also discuss risk reward ratio calculation, practical examples and best practices for using the risk-reward ratio to make informed investment decisions.

What is risk-reward ratio?

The risk-reward ratio is a metric used in investment to assess the potential return of an investment against the risk taken to achieve that return. It is calculated by dividing the potential loss by the potential gain, helping investors evaluate whether the possible rewards justify the risks involved.

Also Read: What is Sharpe Ratio

Understanding the meaning of risk-reward ratio with an example

The risk-reward ratio provides a measurement of the expected rewards relative to the potential risks involved in an investment. For instance, if an investor in India is considering buying shares of XYZ company at Rs. 3,000 per share, expecting the price to rise to Rs. 3,300, the expected reward per share would be Rs. 300. If the investor sets a stop-loss order at Rs. 2,900 to limit potential losses, the potential risk per share would be Rs. 100. Thus, the risk-reward ratio would be:

Risk-Reward Ratio = Potential Risk / Expected Reward = Rs. 100/Rs. 300 = 1:3

This indicates that for every Rs. 1 of risk, the potential reward is Rs. 3. Such a ratio helps investors decide if the investment aligns with their risk tolerance and investment goals.

Formula of risk-reward ratio

The calculation with risk-reward ratio formula is simple and straightforward:

Risk-Reward Ratio = Potential Risk / Expected Reward


Steps to calculate:

1. Determine potential risk:

  • Identify the entry price of the investment.
  • Set a stop-loss order to limit potential losses.
  • Calculate the difference between the entry price and the stop-loss price to determine the potential risk.
2. Determine expected reward:

  • Estimate the target price of the investment.
  • Calculate the difference between the target price and the entry price to determine the expected reward.
3. Calculate the ratio:

  • Divide the potential risk by the expected reward.
This ratio helps investors assess whether the potential return justifies the risk, aiding in more informed decision-making.

Also Read: What are profitability ratios

How to calculate the risk-reward ratio?

To calculate the risk-reward ratio, follow these steps:

  • Identify entry point: Determine the price at which you plan to enter the trade.
  • Set stop-loss order: Decide on the stop-loss price to limit potential losses.
  • Estimate target price: Predict the price at which you plan to sell the investment.
  • Calculate potential risk: Subtract the stop-loss price from the entry price.
  • Calculate expected reward: Subtract the entry price from the target price.
  • Divide risk by reward: Use the formula to find the risk-reward ratio.
This process helps investors evaluate whether an investment's potential return is worth the associated risk.

Also Read: What is the solvency ratio

Examples

Example 1

An investor buys ABC company’s shares at Rs. 2,000, expecting them to rise to Rs. 2,400. They set a stop-loss at Rs. 1,900. The risk-reward ratio is:

Risk-Reward Ratio = Rs. 100 / Rs. 400 = 1:4

Example 2

An investor buys XYZ company’s shares at Rs. 1,500, expecting them to rise to Rs. 1,650. They set a stop-loss at Rs. 1,450. The risk-reward ratio is:

Risk-Reward Ratio = Rs. 50 / Rs. 150 = 1:3

Also Read: What is Current ratio

Benefits of using risk-reward ratio

Using the risk-reward ratio offers several benefits:

  • Informed decision-making: Helps investors make well-informed decisions by comparing potential risks and rewards.
  • Risk management: Aids in setting appropriate stop-loss and take-profit levels to manage risks effectively.
  • Objective assessment: Provides a clear, objective measure to evaluate investment opportunities.
  • Discipline: Encourages disciplined trading by helping investors stick to their predetermined risk and reward parameters.
  • Profit potential: Identifies opportunities with favorable risk-reward ratios, enhancing potential profitability.
By incorporating the risk-reward ratio into their strategies, investors can improve their decision-making processes and manage risks more effectively.

What is the ideal risk-to-reward ratio?

The ideal risk-to-reward ratio varies based on individual risk tolerance and investment goals. However, a commonly recommended ratio is 1:3, meaning the potential reward should be at least three times the potential risk. This ratio ensures that even if some trades incur losses, the overall profitability remains positive due to higher rewards from successful trades. It helps investors balance risks and rewards effectively, promoting better long-term returns.

Also Read: Financial Ratio Analysis

Stop-loss and take profit in risk-reward ratio calculation

Stop-loss and take-profit levels are crucial in calculating the risk-reward ratio. The stop-loss order defines the maximum acceptable loss, while the take-profit order specifies the target profit level. By setting these levels, investors can calculate the potential risk (difference between entry price and stop-loss) and the expected reward (difference between entry price and take-profit). This calculation helps in determining the risk-reward ratio, guiding investors in making informed trading decisions and managing risks efficiently.

How to make an informed decision with a risk/reward ratio?

To make an informed decision using the risk-reward ratio, follow these steps:

  • Calculate potential risk: Determine the stop-loss level to understand the maximum possible loss.
  • Estimate expected reward: Set a realistic take-profit level to estimate potential gains.
  • Evaluate the ratio: Divide the potential risk by the expected reward.
  • Compare with ideal ratio: Ensure the ratio aligns with your investment strategy, typically 1:3 or better.
By systematically applying these steps, investors can assess the viability of trades and make decisions that balance risk and reward effectively.

Limitations of using risk-reward ratio

While useful, the risk-reward ratio has limitations:

  • Estimation dependence: Relies on accurate estimates of risk and reward, which can be subjective.
  • Market dynamics: Does not account for changing market conditions that can impact risk and reward.
  • Execution challenges: Setting stop-loss and take-profit levels may not always be practical or achievable.
These limitations highlight the importance of using the risk-reward ratio alongside other tools and analysis for comprehensive investment decision-making like in mutual funds schemes.

Key takeaways

  • The risk-reward ratio is a key tool in investing and trading that helps you weigh the potential return against the risk you're taking. It compares how much profit you could make (the reward) to how much you might lose (the risk).
  • A higher ratio means a bigger potential reward for the risk, while a lower ratio means the reward might not be worth the risk.
  • This ratio is crucial for investors and traders when evaluating and comparing different investment opportunities or trading strategies.

Final word

The risk-reward ratio is a fundamental tool for investors and traders to evaluate potential investments and trading strategies. By comparing the possible profit against the potential loss, it helps in making informed decisions that align with one's risk tolerance. Whether you're a seasoned investor or just starting, understanding and utilising the risk-reward ratio can enhance your investment strategy and help achieve your financial goals.

For those looking to explore diverse investment opportunities, the Bajaj Finserv Platform offers access to 1000+ mutual funds. This platform provides a convenient and comprehensive solution like comparing mutual funds and a mutual fund calculator for managing your investments, ensuring you have the resources needed to make informed and strategic financial decisions.

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Frequently asked questions

What is a good risk reward ratio?
A good risk-reward ratio is typically 1:3 or higher, meaning you aim to make three times the potential loss on an investment or trade.

What does a 2 1 risk to reward ratio mean?
A 2:1 risk to reward ratio means the potential reward is twice the potential loss. For instance, if a trader risks Rs. 100, they expect to make Rs. 200 if the trade is successful.

Is 1 to 1 risk reward ratio good?
A 1:1 risk reward ratio is generally not considered good because it suggests that the potential gain is equal to the potential loss, making it less favourable compared to higher ratios.

Is a higher reward to risk ratio better?
Yes, a higher reward to risk ratio is better because it means the potential reward outweighs the potential risk, which can lead to more profitable trades over time.

What is the formula for risk to reward?
The formula for risk to reward is: Risk-Reward Ratio = Potential Risk / Expected Reward

What is a bad risk-reward ratio?
A bad risk-reward ratio is typically anything lower than 1:1, where the potential loss is equal to or greater than the potential gain.

What does 1.5 risk-reward ratio mean?
A 1.5 risk-reward ratio means that the potential reward is 1.5 times greater than the potential risk. For example, if you risk Rs. 100, you aim to gain Rs. 150.

Is 2 a good risk reward ratio?
Yes, a 2:1 risk reward ratio is considered good as it indicates that the potential reward is twice the potential risk, providing a favourable balance for profitable trades.

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