What is Risk-to-Reward Ratio and How is It Calculated

The stock market is one of the riskiest places to generate returns on your investment. But the higher level of risk is compensated with significantly higher potential returns. Whether you’re just getting started or are already a professional trader or investor, every trade you place comes with a certain level of risk.The amount of risk you’re comfortable with in order to book a certain amount of profit is something you should be aware of before every trade. The risk-to-reward or R/R ratio is used for making this comparison. Here’s everything you should know about the R/R ratio-

The risk-to-reward ratio is used for assessing the potential profit (reward) against the potential loss (risk) of a trade. Stock traders and investors use the R/R ratio to fix the price at which they'll exit the trade, irrespective of whether it generates profit or loss. A stop-loss order is generally used to exit the position in case it starts moving in an opposite direction to what a trader anticipated.The relationship between the risk and reward helps determine whether the potential returns outweigh the risk and vice versa. In short, the R/R ratio helps traders determine whether a particular trade is worth taking or not.

To calculate the R/R ratio, you first need to figure out the potential profit and loss a trade could result in. Traders are free to set these levels as per their preference and risk appetite.Here’s the formula used for calculating the risk-to-reward ratio - R/R Ratio = (Entry Price - Stop Loss Price) ⁄ (Target Price - Entry Price) For instance, let's assume that you're purchasing 100 shares of a company at Rs. 700. You place the stop-loss at Rs 690 and decide to book profits at Rs. 720. Thus, on every share, you're taking a potential risk of Rs. 10 for a potential profit of Rs 20.If we replace these values in the R/R ratio formula, then it will look like this-R/R Ratio = (700 - 690) / (720-700)R/R Ratio = 10 / 20R/R Ratio = 1 / 2Thus, the R/R ratio in this trade is 1:2.

It is generally recommended that one should only trade if the R/R ratio is lower. In other words, the potential profit should outweigh the potential risk and not the other way around. However, the ratio shouldn’t be too low.In India, the majority of the intraday and swing traders stick to the 1:2 R/R ratio. Thus, for every Rs 2 profit, they're willing to risk Rs 1. However, you're free to adjust the ratio as per your trading expertise and risk appetite.Also, it is not mandatory to have a single R/R ratio for every trade. The ratio can be adjusted as per the stock you’re trading and the prevailing market conditions. But avoid picking trades where the risk potential is significantly higher than the profit potential.

Once the R/R ratio is calculated, you should immediately place the stop-loss order and exit order after taking the entry. For instance, if the R/R ratio is 1:2 and your entry price is Rs. 500, then you can place the stop-loss order at Rs. 490 or Rs. 480 and exit (book profit) order at Rs. 520 or Rs. 540. In both cases, the R/R ratio will be 1:2.If the price starts falling, then the stop-loss order will automatically exit your position at Rs. 490 or Rs. 480 as per what you’ve selected. The loss here will be Rs. 10 or Rs. 20 multiplied by the number of shares purchased.Similarly, if the price rises, then your trade will be squared off automatically at Rs. 520 or Rs. 540, resulting in a profit of Rs. 20 or Rs. 40 per share.

The risk-to-reward ratio is one of the most important things that traders and investors should watch out for before placing a trade. Once you’ve calculated the R/R ratio for a trade, you can place your stop-loss order to limit the losses. Similarly, you can also place the book profit order to exit the position at your preferred price.If you are new to stock trading, then a 1:2 R/R ratio should be ideal. You can start experimenting after gaining some experience. But as stock trading is risky, do your own research before you start investing. You can also consult an investment advisor if your goal is to build a long-term stock portfolio.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.