Risk ratio, also known as reward-to-risk ratio, is a measure used in trading to determine the potential return on an investment compared to the potential loss. It is calculated by dividing the potential profit (reward) by the potential loss (risk). A high risk ratio indicates a higher potential return for a given level of risk, while a low risk ratio indicates a lower potential return for a given level of risk.
For example, consider a trade where a trader buys a stock for $100 and sets a stop-loss order at $90, which means that if the stock falls to $90, the trader will automatically sell to prevent further loss. If the stock rises to $120, the trader will make a profit of $20, which is the difference between the purchase price and the selling price. In this case, the risk ratio is 2, as the potential profit is twice the potential loss.
Another example is a trade where a trader buys a stock for $100 and sets a stop-loss order at $90, and a take-profit order at $110, which means that if the stock rises to $110, the trader will automatically sell to take the profit. If the stock falls to $90, the trader will automatically sell to prevent further loss. In this case, the risk ratio is 1:1, as the potential profit and potential loss are equal.
It is important to note that a high risk ratio does not always mean that a trade is good or profitable. A high risk ratio can also indicate a high level of volatility, which can lead to a greater chance of loss. It is also important to consider other factors such as the overall market conditions, the company’s financials and other technical indicators.
In addition, in order to use risk ratio effectively, a trader must also understand position sizing, which refers to the number of shares or contracts that are bought or sold in a trade. The position size is determined by the amount of capital that a trader is willing to risk on a trade. A trader who is willing to risk more capital on a trade will be able to take a larger position, which can potentially increase the potential return on investment.
There are several key points to keep in mind when using risk ratio in trading:
- A high risk ratio does not always mean a trade is good or profitable.
- A high risk ratio can indicate a high level of volatility, which can lead to a greater chance of loss.
- Risk ratio should be considered in conjunction with other factors such as overall market conditions and company financials.
- Position sizing is an important aspect of using risk ratio effectively.
- Risk ratio is often used as a key metric in money management strategies.
In conclusion, risk ratio is a useful tool for traders to evaluate the potential return on investment compared to the potential loss in a trade. It is important to use risk ratio in conjunction with other factors such as overall market conditions and company financials, and to understand position sizing in order to use it effectively