Trading financial markets, especially the crypto market, involves losing money, not only making it. That’s why all investors and traders should do some preliminary calculations before entering a trade. If you plan to open a position, you need to know how much you are willing to risk and what returns you expect from your trade. This expected risk and return can also be called a risk/reward ratio.
To control risk, traders use a stop-loss order, and to reap the rewards, they use a take profit order. The difference between the stop-loss order and take profit order from your entry will adequately measure your risk/reward ratio. These two measurements help traders to evaluate the potential risk and reward for an upcoming trade and decide whether it’s worthwhile taking it.
The most typical example of risk/reward ratio is 1:2, which means that for every $1 you risk, you expect to make $2. It is the minimum requirement for most traders, as a lower ratio would cause you to lose in the long run. Many long-term traders even use higher ratios such as 1:3 or 1:4. The ratio is significant for traders of highly speculative markets such as Forex and cryptocurrencies, as higher risks cause faster depletion of funds. Thus, applying an adequate risk/reward ratio with a sound account risk (no bigger than 2% per trade) would help traders survive and eventually thrive in the markets.
How to determine an adequate risk/reward ratio?
That’s not an easy question to answer. Trading and investing strategies differ, and so do the personalities of traders/investors who use them. A 1:2 ratio is widely accepted as a bare minimum for any kind of trading.
However, day traders and scalpers may use a 1:1 or 1:0.5 ratio as there is not enough space for a higher one due to the average daily distance that price can travel within a short period. In other words, if BTC/USD average daily range fluctuates from 2.5% to 3.5%, there is simply no space to make take-profit target (reward) two or three times higher than stop loss (risk).
On the other hand, long-term traders who trade market swings and trends will probably seek to increase the ratio to 1:5, or 1:10, because when trends start, price travels long distances giving investors/traders a lot of space to reduce their risk and increase their rewards. Thus, traders need to adapt the risk/reward ratio to their trading strategies and personalities.
An example of how to calculate the risk/reward ratio with BTC/USD
The ratio is easy to calculate. Suppose you want to open a buy (long) position in BTC/USD pair. The price is fluctuating around 43,500. You want to use a 1:2 ratio with a stop-loss that would not risk more than 2% of your account. You determine that the safe place to move your stop-loss is just below the most recent low of 42,700. Thus your risk in units is 800. You multiply the number by two, and you get 1,600. So, your risk is 800 and reward 1,600 units, which equals to risk/reward ratio of 1:2.
Use TradingView charts to determine the risk/reward ratio
TradingView chart (available on CEX.IO Broker) have a risk/reward ratio tool, which can help you tremendously if you struggle to find out how to calculate the ratio. It is on the left side of your chart. Click on the tool as is shown below, and choose Long position if you want to buy and Short position if you want to sell.
So, we choose a Long position and click on the spot in the chart where we want to buy BTC. We then drag the box in the red color to the location where we want to place our stop and then the box in the green color, where we want to take your profit. The middle line indicates your entry price. You can see all numbers on the box: your entry, stop loss, take profit, and risk-reward ratio. You can see where your stop loss and take profit should be to fit the ratio of 1:2 if the entry price is 43,547. We made this one for you.
TradingView can also help you precisely calculate your account risk percentage on a single trade. You click on the settings button, and a window will open, where you can adjust the metrics to your account size to limit your potential loss to 1% or 2%, or whatever percentage you choose (not recommended more than 2%).
Change the inputs to fit your preferences, and you will be able to know how your stop loss has to be adjusted to your account size and your preferable risk limit.
Will you be profitable if you use a high risk/reward ratio?
The risk/reward ratio is a valuable tool for all traders, but it is far from perfect and should not be used alone. Why? Because your winning rate can be meager despite your ratio is high. If that is the case, you can be losing even if your risk/reward ratio is 1:2 or even 1:3. How is that possible?
It’s pretty simple. If on average, you lose 8 trades out of 10, your account is decreasing steadily as your wins cannot cover your losses. Imagine you risk $100 on a single transaction, and your expected reward is $200. So, out of 10 trades, you would have lost $800 and won $400. That is a $400 loss on 10 trades. The same is valid for risk/reward 1:3. If you risk $100 and win $300 out of 10 trades, you would lose $800 and win $600. That is a $200 loss on 10 trades.
You need to increase your winning rate to stay ahead of the game. You do that by working on your strategy, the timing of your trades, improvement of your trading tools (indicators, chart patterns, candle patterns, support and resistance lines), and understanding of fundamental picture of a particular instrument you are trading.
Final thoughts
The risk/reward ratio is a valuable tool in trading that helps you limit your risk and increase profits. It is easy to calculate and is beneficial in determining where to place your stop loss and take profit orders. However, it should not be used alone but with other technical and fundamental tools to achieve better results. Improving your winning rate is also of uttermost importance as you can continue losing more if your winning rate is low, despite the fact that your risk/reward ratio is high.
For information purposes only. Not investment or financial advice. Seek professional advice. Digital assets involve risk. Do your own research.
