Risk Reward Ratio – What it is?
Let us take an example to understand. You buy 100 shares of ABC company at Rs.50.
You expect the price of this share to rise from Rs.50 to Rs.60.
At the same time if the trade goes against your expectation you fix a stop loss to sell the share if the price falls below Rs.45.
Thus you expect a reward of Rs.10 at a risk of Rs.5. Your risk-reward ratio is 2:1.
As a stock trader you carry a certain level of risk while trading. You should know the amount of risk that you are carrying. It is one way to limit your losses and preserve your capital in the long term. The best way is to know your risk-reward ratio and effectively use it in all your trades.
It is not an easy task to fix your risk-reward ratio. All kinds of emotions come into play, including greed. You should avoid a situation where your trade is going against you and you are hoping the trend will reverse but you only see the losses mounting. To avoid such situations, you should fix a risk-reward ratio that suits your trading pattern, which is logically based on your past trade experiences and your total capital invested.
The two major factors that go into fixing your risk reward ratio are the
- Stop Loss level [more… ]
- Stop Profit level [more…]
A risk-reward ratio should never be less than 1:2 – that is for every rupee risk there should be a potential reward of two rupees. Any ratio less than this is a sure way for failure and losing your capital.
Your winning trades alone is not going to tell you anything about the amount of profits you are making. Look at this example:
Say there are two traders. For one 75% of all his trades are winning trades and for the other 40% of all his trades are winning trades. From this can you say which trader is more profitable. No, it is not possible to say only based on the winning trades. Unless we know how much profit each trader makes when his trade is a winning trade and how much loss he is making in a losing trade.
If your goal is to be a profitable trader then you need to have a risk-reward ratio in place before you enter into trading in stocks. This is one of the most important tool in risk management and which will consistantly help you in becoming a profitable trader when used in combination with you winning trade ratios.
