How to get hold of the risk factor and reward ratio?
The risk to reward ratio is a ratio investor use to compare the probable returns out of a certain investment to the amount of risk they take to get these returns. The ratio has an arithmetical formula.
Divide the risk - the amount the investor will lose if the price moves in a negative direction by the reward - the profit the investor can make when the position is closed. The traders should not have a 1:1 risk to reward ratio, as it indicates the potential loss over the investment will be much higher than any predictable profit.
A good risk to reward ratio is 1:2 which indicates the profit or reward is higher than the loss. In a situation, where the trading suffers any loss, the trader is assured definite break-even profit margin.
Let us look into the illustration: A trader purchases 100 shares for XYZ Company for Rs.20 and fixes a limit of R.15 stop loss order to make sure his/her loss will not go beyond Rs.500.
Let us presume, the trader anticipates the price of XYZ to reach Rs.30 in a few months. This indicates that the trader is enthusiastic to go under a risk of Rs.5 for every share to make an expected return go Rs.10 for every share after closing the deal.
Since the trader here is likely to make a profit double the risk, the risk to reward ratio is 1:2 on this trading. Trial and error method is best to In order to determine the best-suited ratio for every individual trading, trial and error method would be the best option.
Conclusion: The risk to reward ratio calculation offers the traders a rough idea about the likely outcome of the trading done; providing them a chance to work on plan B in case a loss is incurred. It is relevant to the share market, Indian stock market, national stock exchange, equity market or the stock trading scenario. Permutation, combination and specialist help will get good returns on investments.