A good trading strategy is often not enough to bring consistent profits from cryptocurrency trading. Profitable traders usually have to play some tricks over the market to achieve their ultimate financial goals.
Most traders spend their time studying the price chart, looking at the historic 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.
Knowing what’s a good risk-to-reward ratio can help plan a proper risk management strategy and also determine whether you’re going to be a successful trader in the long run and achieve your financial goals — or simply rely on luck in the short term.
Whether you’re a beginner or experienced trader, this guide will introduce you to the nuts and bolts of the risk/reward ratio, including its use, calculation method, and risk management to minimize losses.
What Is the Risk/Reward Ratio?
The risk/reward ratio defines the relationship between the potential hazards and gains for any given trade. It is a process to assess the difference of entry points, stop loss to take profit orders based on the RR ratio. In every trading strategy, the ideal approach is to get maximum reward against minimum risk.
Traders can identify risk by finding the price gap between the opening point and the stop-loss order. On the other hand, the profit targets indicate a price level where a trader should get out of the market with a considerable gain. Traders can identify the take profit level by measuring the distance between the entry point and the profit target.
The stop-loss trading order automatically sells the instrument once the price reaches the lowest determined price level. Thus, it minimizes the potential risk by allowing an investor to get out of the market without experiencing further losses. If the market reaches the stop-loss level, the order will automatically close to prevent further loss on the trading account if the price drops even lower.
The relationship between the stop loss and take profit helps to identify the ideal reward from potential risk. Taking these measures is an active way to hone your trading strategy.
How to Calculate Risk/Reward Ratio
Traders should calculate the risk they are taking per trade vs. the reward they are getting 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 will lose, as determined by the stop-loss order. In other words, it is the gap 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 dividend by the reward.
We can calculate it following this simple formula:
If the ratio is greater than 1, you have taken a lower risk to get higher returns. The three possible outcomes of the calculation are as follows:
- Risk > Reward
- Risk < Reward
- Risk = Reward
Among these three cases, we aim 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 to keep the potential profit at a certain level.
Below is an example of a trade with a positive risk/reward ratio:
In the above image, we can 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 = (44738 − 43676) / (47591 − 44738)
The risk/reward ratio here would be 0.37.
What Does the RR Ratio Tell you?
Finding the trend in the volatile cryptocurrency market can be challenging regardless if you’re using technical analysis or fundamental analysis. The risk/reward ratio remains one of the most important risk management tools to help critically identify a trade entry point to a stop-loss or take-profit order. Traders usually identify the 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 losses, as no one knows the future.
Therefore, the significant volatility and the possibility of a market crash make using the risk/reward ratio compulsory for cryptocurrency trading. As such, using stop losses in every trade is compulsory for all traders. 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.
What Is the Optimal Risk/Reward Ratio?
In every trading strategy, obtaining higher returns is the primary goal. That’s why a risk/reward ratio of 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 one uses.
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:
E = [1 + (W/L)] × P − 1
- W = Average win
- L = Average loss
- P = Winning rate
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 make a profit, you earn $6,000 while losing $2,000 on your four losing trades. Then 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.
Now, let’s apply the formula:
E= [1+ (1000/500)] x 0.6 – 1 = 0.80
Therefore, your trading expectancy of 80% is very high.
Can You Rely Only on R/R Ratio to Trade?
The risk-reward ratio plays a vital role, although a good R/R ratio does not ensure profitability. It is a tool to protect against the unexpected market movement that could wipe out the profit potential. Besides using an appropriate R/R ratio, take other factors into consideration as well:
- Proper knowledge about the market and apply market research into the risks associated when trading.
- Thorough and profitable trading strategies, using a lot of backtesting before proceeding with real money.
- Risk per trade, defined as the amount of capital you’re risking and the potential win rate on a single trade.
Overall, it’s recommended that you stick to a set of rules written into your trading checklist in order to get the ultimate benefit from the market.
Technical Indicators and R/R Ratio to Maximize Rewards
You cannot rely on the risk/reward ratio alone when trading. Trading or investing without proper managing the 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 is no place for guessing the price or gambling.
To do so, here are a few steps you need to look into.
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 with a minimum loss.
Price action, or the price movement of an asset plotted over time on a chart, is the characteristic of a trading instrument that defines what buyers and sellers are doing in the market. If you read a chart carefully, you’ll see that the price respects some price areas multiple times. If we can set the stop loss from these support and resistance levels, the price is more likely to bounce back.
An example is outlined below:
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 rate.
Another approach is using trend line support or resistance, from which the price often rebounds in a timely fashion.
The above image shows how the price bounces back from the trend line support. The candlesticks show the price correcting from the trend line and moving higher. Moreover, the reward/risk ratio is above 1:1 for each trade.
Besides static or trend line support, prices often get rejected from dynamic levels. The exponential moving average (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 is 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 an approximately 1:4 risk/reward ratio.
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 the risk using support resistance and moving averages. The same rules apply to measuring reward. 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.
A tool called the Fibonacci extension is used to identify the possible price targets. The primary approach is to consider the 161.8% extension level as a major price target.
The above image shows how the Fibonacci extension level works as a major price reversal point. For example, if you buy after breaking the 61.8% correction of the swing level, the major take-profit level should be at 161.8%.
Pros and Cons of the Risk/Reward Ratio
The risk/reward ratio is not the most significant element in trading. Besides setting a reasonable take-profit level, you have to learn how to maximize your profits and minimize your losses.
One common mistake is for day traders to have a risk/reward in mind before analyzing the market. This can lead them to set the stop loss and take profit levels based on their entry point. However, they need to consider the value of their investment, risk per trade, and market conditions surrounding that trade.
The best risk/reward ratio should strike a balance between higher reward and lower risk. The following trading plan may help increase the probability of winning, besides offering an excellent risk/reward ratio:
- Suitable market conditions
- Identification of the active trading session to enter a trade
- Finding the appropriate price levels to set the stop loss and take profit in those market conditions
- Considering the probability of winning and losing trades and the break-even percentage.
The Bottom Line
The key points regarding the R/R ratio in the crypto market are as follows:
- Low risk/reward ratio alone is inadequate information for trading.
- Traders must know how to achieve reward levels utilizing a trading method.
- Traders need to have considerable knowledge about market conditions before opening a trade.
- Have a reasonable trading plan in order to make the best use of the risk/reward ratio.
The risk/reward ratio is not the ultimate measure of knowledge of trading. It is an excellent tool, but traders need strategies for winning trades and good trade management.