In order to make rational decisions on the market, traders have to calculate and consider the relation between risks and rewards, or potential profits and losses. This seems to be the most basic factor for every trade, so each novice trader should definitely learn how to define and use this ratio as soon as possible. In this article, we explain how to calculate the ratio, how risks and rewards usually correlate, and how to use your calculations to avoid losses.
How risks and rewards correlate
Basically, the more you are ready to risk, the higher your profits can be, and vice versa, the less you are willing to risk, the less you can earn. The actual ratio between risks and profits can be very useful for determining how to place your stop-loss and take-profit orders. As a rule of thumb, this ratio should be higher than 1:3. That means you should expect to receive at least $30 from a trade where you risk just $10. The more you avoid risks, the higher this ratio will be for you.
Some traders who don’t fear high risks use a 1:2 or even 1:1 ratio. Scalpers are especially well-known for their low risk reward ratio values. They usually trade in extremely volatile markets trying to receive tiny profits from each trade. Scalpers often set their stop-loss orders further than the expected profit, so their ratio of profits and risks becomes even lower than 1:1. They should also think about spreads and fees charged by their brokers, and that’s why scalping is pretty risky.
Why low ratios are risky
If you can trade with a low ratio of risks and rewards, you can take on more risks and thus make more profits. However, psychological impact is an important thing to consider here. More risk is more stress, and when you suffer from stress for too long, you start making bad decisions. Your losses start to pile up, and you can end up losing all of your capital without any chance to recover. That’s why you should evaluate trades soberly and take time to calm down.
Using the risk-to-reward ratio
The ratio itself is easy to calculate. For example, you want to buy an asset for $100 and expect to sell it for $120. The estimated profit is $20. If you set a stop-loss order at $95, your maximum loss will be just $5. The ratio is defined as $5 / $20, or 1:4. You can use it to decide where to set a stop-loss order for your trade. For example, an asset costs $100, and you expect to earn $80 for $1 per point, and the risk-to-reward ratio is 1:4, so your stop-loss order should be set at a distance of 20 points.