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The risk-reward ratio help defines the difference of entry points, stop loss and take profit to minimize risks. Learn how to hedge against risks & maximize your potential reward.

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A good trading strategy is often not enough to bring consistent profits from crypto trading. Profitable traders usually have certain methodologies they use to achieve their ultimate financial goals.

Most traders spend their time studying price charts, reviewing historical data and looking for the next big opportunity. While these are constructive activities that everyone needs to attend to, not every trader takes the time to focus on the potential loss or profit relative to the risk taken.

Being able to recognize a good risk-to-reward ratio can help you plan a proper 

 and determine whether you’re going to be successful in the long run and achieve your financial goals — or simply get lucky in the short term.

Whether you’re a beginner or an experienced trader, this guide will introduce you to the fundamentals of the risk/reward ratio, including its use, calculation method and risk management, in order to minimize your losses.

The risk/reward (RR) ratio defines the relationship between the potential losses and gains for any given trade. It’s determined by the difference in entry price from the stop-loss and take-profit price. In every trading strategy, the ideal approach is to obtain maximum reward against minimum risk.

Traders can identify risk by finding the price difference between the entry order and the stop-loss order. On the other hand, profit targets indicate a price level where a trader can exit the market with a considerable gain. Traders can identify the reward by measuring the distance between the entry point and the profit target.

A stop-loss trading order automatically sells your cryptocurrency once the price reaches the 

. If this occurs, the order will automatically close to prevent further loss on the trading account, should the price drop even lower.

The difference in percentage between the stop-loss and take-profit level helps to identify the RR ratio, and is an effective way to hone your trading strategy. A low RR ratio is also known as asymmetric risk reward, in which the potential gains from an investment are far greater than the possible losses — and the risk is worth taking.

Traders must calculate the risk they’re taking per trade vs. the reward they stand to gain in order to determine the risk/reward ratio. In manual trading, traders analyze and set these levels before opening a position.

Risk is the amount of money a trader may lose as determined by the stop-loss order. In other words, it’s the difference between the stop-loss order and the entry price. Similarly, the reward is the potential profit set by the trader. We can measure it by calculating the distance between the entry point and the profit target.

The risk/reward ratio is the quotient we obtain when dividing the risk by the reward. 

We can calculate it following this simple formula:

If the ratio is less than 1, you’ve taken a lower risk to get higher returns. The three possible outcomes of the calculation are as follows:

Among these three cases, the aim is to keep the risk lower than the reward so that every time the trade hits the stop loss, your loss is minimized. The ultimate goal is to keep the risk as low as possible in every trade in order to maximize potential profit.

Below is an example of a trade with a desirable risk/reward ratio:

In the above image we see the stop loss, take profit and entry point. Now, let’s plot them in the formula and identify the risk/reward ratio.

Risk/reward ratio = (44,738 − 43,676)/(47,591 − 44,738)

The risk/reward ratio here would be 1:2.68, which is less than 1.

Finding the trend in the volatile cryptocurrency market can be challenging, regardless of whether you’re using 

. The risk/reward ratio remains one of the most important tools to help critically identify a trade entry point, a stop-loss or a take-profit order. Traders usually identify price direction by using multiple technical and/or fundamental tools. However, even if you follow a good trading strategy, there’s always the possibility of loss, as no one knows the future.

Therefore, crypto’s high volatility and unpredictable market make using the risk/reward ratio compulsory for cryptocurrency trading. As such, using a stop loss in each trade is essential. Moreover, it can help you increase the probability of winning trades. It isn’t wise to risk all of your investment in a single trade, nor does it make sense to risk $1,000 for a $100 gain. Again, most analysts advise a risk/reward ratio of no greater than 1:2, or 0.5, for recommended trades.

In every trading strategy, obtaining higher returns is the primary goal. That’s why a risk/reward ratio of no greater than 1:2, i.e., with a maximum value of 0.5, is recommended. However, there are no fixed rules of use, as it depends on the expectation and the strategy you use.

Let’s have a look at the concept of trading expectancy, or the average profit for each trade placed by an investor, using the following formula:

Finding the expectancy and matching it with the risk/reward ratio is important for day traders and swing traders. For example, if you make ten trades, of which six are profitable, your win rate is 6/10 or 60%.

Now, let’s say that of those ten trades from which you’ve made a profit, you earn $6,000, while losing $2,000 on your four losing trades. In this case, your average win should be $6,000/6 = $1,000, while the four losing trades with $2,000 loss produce an average loss of $2,000/4 = $500.

Therefore, your trading expectancy of 80% is very high.

The risk-to-reward ratio plays a vital role in making trades, although a good R/R ratio still doesn’t ensure profitability. It’s a tool designed to protect against unexpected market movement that could wipe out profit potential. Besides using an appropriate R/R ratio, take other factors into consideration as well:

Overall, it’s recommended that you stick to a set of rules written into your trading checklist in order to obtain the ultimate benefit from the market.

Technical Indicators and R/R Ratio to Maximize Rewards

Clearly, you cannot rely solely on risk/reward ratio when trading. Trading or investing without properly managing position sizing and a good R/R will only maximize your risks. Financial trading requires a systematic approach to increase the potential reward, and there’s no place for guessing the price or gambling.

Here are a few steps to take in order to increase your success and reduce your risk.

Setting a Stop Loss by Defining the Risks

The risk per trade is the difference between the entry point and the stop loss level. The stop-loss level is the exit point where your trade should close automatically in order to minimize loss.

Price action, or the price movement of an asset plotted over time on a chart, defines what buyers and sellers are doing in the market. If you read a price chart carefully, you’ll see that price often respects certain 

 multiple times. If we can set the stop loss from these, the price is more likely to bounce back.

In the above image, we see that Bitcoin moves higher from the strong support of $30,000. Therefore, buying from that level with a risk below $30,000 creates a higher probability of a win.

Another approach is using trend line support or resistance, from which the price often rebounds in a timely fashion.

The above image shows the price bouncing back from the support trend line, with the candlesticks showing the price correcting from the trend line and moving higher. 

Besides static or trend line support, prices are often rejected from dynamic levels. The 

 (EMA) is a great example of dynamic support and resistance level. EMA is a type of moving average that smooths out prices by placing more weight on the most recent price action. For example, if the price approaches the 20-period EMA, there’s a high probability that the moving average will act as a dynamic support or resistance level.

In the above chart, we can see how the price moves higher from the dynamic support. In this regard, it’s safe to place the stop loss below the 20 EMA. Therefore, the price rebounds and moves higher with a risk/reward ratio of approximately 1:4. 

How to Set a Proper Target Profit to Minimize Risks

Before making a trade, it’s recommended you measure the risk and reward. In the above section, we’ve seen how to measure risk using support resistance and moving averages. The same rules apply to measuring rewards. If the price moves higher and reaches any significant resistance level, it has a higher probability of reacting at these price levels. 

Above is an example of how to set the take profit, based on resistance levels. Here, 40,000 works as a significant price reversal point, from which the price moves lower, making the level significant. Therefore, if you’ve bought BTCUSD after the rejection at 30,000, the goal for your take profit should be 40,000.

 is used to identify possible price targets. The primary approach is to consider the 161.8% (1.618) extension level as a major price target. 

How to Use the Risk/Reward (RR) Ratio for Crypto Trading

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