Understanding the Risk Reward Ratio
In life in general and in trading and investing in particular, there is often a relationship between risk and reward, in that, if you want a bigger reward, you often need to take more risk.
But what is the relationship between risk and reward, and is there an ideal risk reward ratio? Before we examine those questions, it is worth looking at risk and reward separately.
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In trading and investing it is relatively straightforward to understand the concept of reward; it is the profit that we hope will come about from our trade. This profit will come from either a change in the price of whatever we are trading (e.g. buy low, sell high) or from income produced by our investment (e.g., the receipt of dividends or interest payments).
What Is Risk?
Risk is the possibility of not getting the outcome you want. That the share price won’t go up, as you thought, or that a company’s expected dividends are cut, or scrapped altogether.
In trading and investing, risk can be grouped into many different types, depending on the source. For example:
- Liquidity Risk: the risk that you won’t be able to trade in and out of the position you want to take;
- Market Risk: the risk that the whole market falls in price when you are holding an investment;
- Correlation Risk: the risk that all your investments will fall in value at the same time;
- Currency Risk: this exists whenever you buy an asset denominated in a currency different from your own.
- Interest Rate Risk: the risk that interest rates will change and have a negative impact on your investment.
- Inflation Risk: the risk that a change in the rate of inflation will erode or eliminate your expected returns.
- Political Risk: the risk of a political event (an election, a coup, etc.), or a political action (e.g. new legislation) negatively affecting your investment.
Classifying risk as above is useful because you can sometimes hedge, or insure, against the individual risks. For example, you could buy shares in Tesla and at the same time buy Forex derivatives to protect you against a fall in the USD. Or you could buy shares in Shell and at the same time short the price of oil to protect you against the possibility that a fall in oil will negatively affect the value of Shell’s shares.
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There are many ways that risk professionals use to try to measure and quantify risk.
One simple and intuitive way to assess risk is to think about three different factors:
- The number of possible outcomes
- The probability of each of these outcomes
- The total probability of positive outcomes vs. the total probability of negative outcomes
Let’s look at the first of these, the number of possible outcomes.
Would you rather bet all of your savings on the toss of a coin or on your ability to predict the next number when you throw a six-sided die? With the coin, you have a 1 in 2 (50%) chance of winning. With the die your chances are 1 in 6 (16.67%) - so, hopefully, you chose to bet on the coin flip.
Everything else being equal, the more possible outcomes there are, the riskier the situation.
But the above is only true if the probability of tossing a head is the same as the probability of tossing a tail - and the probability of rolling any one of the 6 numbers on a die is the same.
What if I gave you a die that is weighted so that a 6 is rolled 80% of the time? There are still 6 possible outcomes, but one of them (rolling a 6) is much more likely to happen than all the others put together.
So, you also need to think about the probability of each potential outcome happening. This is our second factor.
The third is to think about how many of the possible outcomes would be positive for you, and add up their probabilities, then add up the probability of the possible negative outcomes. The greater this second number is compared to the first, the riskier the situation.
In the above example, with the loaded die, betting on a 6 would mean a 20% probability of losing vs 80% of winning. That kind of comparison gives you a clearer picture of the risk you are facing. Naturally, this is just a simplified example to illustrate how one would go about quantifying risk, there is a lot more to trading and investing than just flipping a coin or rolling a die.
The Relationship Between Risk and Reward
Now that we understand more about risk and reward as separate concepts, it’s time to look at the relationship between them.
There is a truism in the world of finance, that if you want to gain bigger rewards you have to be willing to take greater risk. The opposite is also true; if you are selling investments, the riskier an investment is, the higher reward you would have to offer to investors for them to consider taking on the extra risk.
Imagine you are an investor who is offered two possible investments A and B. They both have the same potential return but you judge investment A to be twice as risky as investment B. Which one would you choose? Most people would choose B.
When this happens across the whole market, prices for these investments adjust to reflect the relationship that riskier investments tend to offer higher rewards.
In general, there is a progression among the assets listed below of increasing risk and increasing expected rewards:
- Short-term loans or bonds of economically healthy governments;
- Long-term loans or bonds of economically healthy governments;
- Loans or bonds of economically healthy companies;
- Loans or bonds of higher risk (high-yield) companies;
The above list is not exhaustive and there are overlaps between the ranges for each asset class. For example, the shares of a large, established supermarket chain might be considered to be safer than the bonds of some high-yield companies.
The relationship between risk and reward is a very important principle in finance.
What Is the Risk Reward Ratio?
To simplify all of the above, many traders use the risk reward ratio. As the name implies, this is a ratio that compares the maximum potential loss (risk) with the maximum potential profit (reward).
To use the risk reward ratio for a particular trade, a trader would place a stop-loss order, which will limit the potential loss on the trade. They then place a take-profit order, which would secure a profit once a predetermined level has been reached.
How Is it Calculated?
Now that the trader has a maximum potential loss and a maximum potential profit, you simply compare one to the other.
For example, let’s say you decide to buy Apple shares at $135/share. If you simultaneously place a stop loss at $130 and a take-profit order at $160. Now our maximum potential loss (or risk) is $5/share and your maximum potential profit is $25/share, giving you a ratio of 5:25, or 1:5.
Usefulness and Limitations
Disciplined traders and investors will often set themselves a target risk reward ratio and use this when analysing potential positions in the market. It is a useful tool when managing the risk of losing money on trades.
However, just because you set yourself a target 1:3 risk reward ratio on all your trades, that doesn’t mean that you are going to make £3 for every £1 you lose. That’s because simply using a strategy with a high risk reward ratio does not tell you anything about the probability of the market price reaching either the level of the stop loss, or the level of the take-profit.
What Is a Good Risk to Reward?
Unfortunately, there is no simple answer to this question. The best risk reward ratio will vary depending on the situation, your trading style (scalping, day trading, etc.), your appetite for risk and other factors.
The best way to use the risk reward ratio is to calculate each of the two points independently and according to your own analysis; whether that’s fundamental analysis, technical analysis, or both.
Then when you calculate the risk reward ratio, you can use it as a way to realistically compare different potential trades. You can also set yourself a rule; for example, that you won’t do trades with a lower than 1:2 risk reward ratio. These are good steps to get started with your risk reward analysis.
Now that you know more about the risk reward ratio, try to incorporate it into your trading and investing strategies. It is a powerful and simple way to improve your risk management.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.