Managing Trading Risks Using Risk-reward ratio

[TL; DR]

The risk-reward ratio helps traders to minimize trading losses and maximize profits.

Most experienced crypto traders use the 1:1 risk-reward ratio.

A stop loss is a trading tool that automates a trade exit once a price of an asset reaches a set point during a trading session.

A risk-reward ratio may help traders to avoid using emotions when making trading decisions.

Introduction

Among the investment opportunities that exist in the cryptocurrency sector trading is a favourite for many investors since it is very profitable. Nevertheless, it is also risky due to the price volatility of cryptocurrencies. This is the reason why many novice traders fail. In this respect, experts predict that about 80% of new traders fail. Usually, the ones who succeed have good risk management skills. The good thing is that traders can use the risk-reward ratio to manage trading risks.

What risks do crypto traders encounter?

A risk is a possibility of making a loss in an investment or business venture. In this case, a trader who puts his crypto resources in trading has a chance to lose all or part of his/her investment.

There are several risks that traders face which include credit risk, legal risk, liquidity risk, market risk and operational risk. However, the risks that mainly affect crypto traders are liquidity risk, cyber risk, market risk and operational risk.

Weighing trading risks- Economictimes

Market risks: These are risks that arise from price movements of cryptocurrencies. For example, the price of a cryptocurrency you have invested in may fall below its current value. This means that the trader faces a loss, unless there is a trend reversal.

Operational risks: Malicious actors such as hackers may attack and steal cryptocurrencies which are on exchanges and other trading platforms. In most cases, the crypto holders fail to recover them. The protocols may also experience system failures and bugs.

Liquidity risk: This refers to the difficulty that traders encounter when they want to convert their cryptocurrencies to fiat money. In some cases, the value of cryptocurrencies decreases before the investors convert them to cash. In extreme cases, traders may not be able to convert one cryptocurrency to another.

Despite the fact that a trader may not be able to prevent all the above risks, he/she may reduce the effects of some risks, especially market risks. One way of doing that is to use a risk-reward ratio.

What is a risk-reward ratio?

The risk-reward ratio is a ratio of the expected profit level of a trade to its potential loss. It is a comparison of the risk taken for an investment and its possible loss. Remember that trading is a type of a short term investment.

A trader uses the stop loss, the entry price as well as the take profit level to establish a risk-reward ratio. It is the individual trader’s risk appetite that determines this ratio.

Let’s use a simple example to help you understand this concept. A risk-reward ratio of 1:5 means that the trader is willing to risk $1 to gain $5. If we use bigger figures than this, it shows that a trader is willing to lose $100 to target a profit of $500.

How to calculate a risk-reward ratio

As said, to calculate a risk-reward ratio you require knowing your stop loss. Simply defined, a stop loss is a trading tool that automatically closes a trading position when it incurs a certain loss. A trader sets a specific price or percentage of the price as the stop loss point.

Different risk-reward ratios- Centerpointsecurities

The trader also needs to know his/her take profit and the entry price. An entry price is the value of a cryptocurrency when a trader enters a trading position. On the other hand, a take profit refers to a target profit for a trade. If the price of a cryptocurrency rises to the set profit level, the system automatically closes the trading position.

The simplest way to calculate the risk-reward ratio is to divide the difference between the entry price and stop loss by the difference between the entry price and the take profit level. The following formula summarizes how to calculate this ratio.

Risk/Reward ratio = (Entry Point - Stop-loss) / (Profit target - entry point)

Let’s focus on an example of a cryptocurrency with the following figures.

Entry price: $50

Stop-loss: $40

Take profit: $70

Calculation: (50 – 40) / (70 – 50) = 10 / 20 = 1.2

What this ratio means is that the trader is willing to risk $10 to gain $20. As a trader becomes more experienced, he/she will establish his/her risk-reward ratio based on the prevailing market conditions.

The ideal situation for a trader is to enter a position when the possibility of a profit is higher than the potential loss.

Why should a trader use a risk-reward ratio?

The risk-reward ratio guides a trader when to close a trade whether it is in a profit making or loss making position. This helps to remove emotions from the trading process. Usually, uncontrolled emotions such as greed and fear result in traders making wrong decisions that lead to losses.

The ratio also safeguards the trader from taking high risks. For instance, if a trader sets a 1:5 risk-reward ratio and sticks to it, he/she will never be tempted to take a larger risk. Therefore, the risk-reward ratio instills discipline in traders which is a requirement for successful trading.

The risk-reward ratio also helps a trader to stick to the rule that he/she should not lose 2% of his/her capital on a single trade. Therefore, a trader first calculates 2% of his/her capital and places the stop loss at an appropriate level to avoid such a loss.

What is the best risk-reward ratio?

In fact, there is no established best risk-reward ratio. This is because the ratio depends on the risk appetite of an individual trader. However, there are a few guidelines to help new traders.

Many experienced traders use a 1:1 risk-reward ratio. In this case, a trader is willing to lose, say $500 to gain $500. Another strategy is to risk $100 to get a profit of $200. In rare cases, a trader may risk $200 to gain $100.

Nevertheless, it is important to note that there is no single strategy to use. It all depends on an individual trader’s preference and the existing market conditions.

Conclusion

The risk-reward ratio helps traders to mitigate trading risks. Traders who use it wisely minimize their trading losses and increase their profit levels. This is because they will be in a better position to set strategic stop loss and take profit levels.

Author: Mashell C., Gate.io Researcher

This article represents only the views of the researcher and does not constitute any investment suggestions.

Gate.io reserves all rights to this article. Reposting of the article will be permitted provided Gate.io is referenced. In all cases, legal action will be taken due to copyright infringement.