RR helps you determine whether a trade is profitable or not.

The Risk/Reward ratio is calculated after developing a trading plan, determining entry and exit points, and determining the level of stop-loss.

The Risk/Reward ratio is calculated for each position individually based on the trader’s trading strategy, taking statistics and opportunities into account.

With proper analysis of the results of one’s trading strategy, a competent Risk/Reward ratio allows one to earn in the long run.

What is RR?

The Risk/Reward ratio is a coefficient that shows the risk to potential profit ratio. The specific value of RR is calculated before buying an asset and allows the trader to assess the transaction’s potential in terms of the trader’s trading strategy.

If the Risk/Reward ratio is greater than 1, the risk outweighs the potential profit. When the value is less than 1, the potential profit exceeds the inherent risks.

Risk in trading and investing refers to the potential loss that a trader is willing to accept when opening a position. Stop-loss orders, which automatically sell an asset when a certain price is reached, are commonly used to control the level of risk. This is an important trading tool for more than just limiting losses. The risk level is an essential component in calculating a trader’s potential profit and his trading strategy as a whole.

Profit is the difference between the purchase price of an asset and the price at which it will be sold. Profit, in the context of the RR ratio, is a potential level that a trader determines before entering a position to assess the potential of a trading operation.

How to calculate RR properly?

The generally accepted method of calculating the RR ratio is to divide the risk by the profit, i.e. RR equals risk divided by profit. Although some traders, due to personal preferences, may use the opposite variant, where profits are divided by risk, we will consider the standard example of calculation, using the formula below:

Assume you want to buy an asset for $100. You’ve also decided to limit your risk by setting your stop loss at $90 and your target price for selling the asset at $130. In this case, the RR ratio will be one to three, or approximately 0.33. In other words, the risk is lower than the potential profit.

The RR ratio would be 2 in the example with the same entry price ($100) and target price ($130), but with a stop loss set at $40. This ratio value indicates that the risk is significantly greater than the expected profit.

Optimal Risk/Reward ratio

One of the most commonly used values in calculating the risk-to-profit ratio is 1 to 3, or 0.33. Also common are ratios of 1 to 7, 1 to 10, and 1 to 15.

Choosing common RR variants, on the other hand, is a serious trading mistake. Based on their experience, statistics, and market conditions, traders must determine which RR ratio is best suited to their trading strategy.

For example, if a trader only makes 50% of successful trades, an RR of 0.5 or 1 to 2 would be of no use. Before entering a trade, the target selling price of an asset should generate a profit statistically, not just in this trade.

The point of RR in the 1 to 3 ratio or 0.33 ratio example is that one profitable trade can cover 3 losing trades. If the ratio is 1 to 5, then one profitable trade must cover 5 losing trades.

Before assessing risks and calculating RR, a trader evaluates the asset’s price movement capability, locates an entry point, and forecasts the asset’s price movement, determining when to exit the position.

Only after you have completed these steps can you calculate the RR ratio. If the coefficient matches a trader’s trading strategy, he enters the position.

Is it necessary to calculate the RR ratio?

If a trader wants to use their trading strategy effectively and control the necessary level of RR to make a profit in the long run, they must calculate the RR ratio.

If the percentage of successful deals is not so high, say 20%, a proper RR ratio can make a trader money in the long run.