risk/reward ratioTo calculate it, a trader needs to define their risk and profit potential from a trade, first.
The risk is determined by a stop-loss order. The risk is from the price difference between the stop-loss order and the entry point. Meanwhile, the profit target establishes a favorable exit point. The potential profit of trade comes from the difference between the profit target and the entry price.
To calculate the risk-reward ratio, you need to divide the risk by the profit potential.
For instance, you buy a stock for $25.0, place a stop loss at $25.50, and set a profit target at $25.85. The risk of your trade, then, becomes $0.10 ($25.60 – $25.50), meanwhile, your profit potential is $0.25 ($25.85 – $25.60).
From the same example, your risk/reward ratio becomes 0.4 ($0.10 / $0.2 = 0.4.
The risk/reward ratio that is bigger than 1.0 represents the trade has a bigger risk than the profit potential. Contrarily, less than 1.0 risk/reward ratio means bigger profit potential than the risk.
A Closer Look on Risk/Reward Ratio
At a glance, 0.1 or 0.2 looks good. Yet, that is not always the case. Traders have to always consider the odds to get the profit target before the stop loss.
You have the chance to make an attractive trade by putting the profit target far away from the entry point. However, you have to consider the chance of it to get hit.
Thus, it is essential for you to balance profit and risk. Make sure the trade still has a chance to reach the profit target before the stop loss.
Commonly, the risk/reward ratio for most day traders falls between 1.0 and 0.25. Investors, day traders, and swing traders should avoid trades with less profit potential. Those trades usually have more than 1.0 risk/reward ratio.
