Stock Chart Trading: Risk Reward Ratio

How to decide on your trade based on Risk Reward Ratio

Before this, we’ve spoken about the basics of trading, such as simple chart patterns you can refer to while confirming your trade, indicators such as volume, moving average, relative strength index, MACD, Bollinger Bands, and Fibonacci Retracement. Apart from these indicators, there are a few more that you might want to learn, but before we get to that, let’s look at one of the key deciding factors of whether you should proceed with the trade or not — and we’ll make it really simple.

What is the Risk Reward Ratio?

The Risk Reward Ratio (RRR) simply tells you how much risk are you taking for how much reward — are you taking a big risk for small crumbs? Are you taking a small risk while looking at huge gains? Or is it a proportionate size of risk and reward? All of this will weigh on your decision.

Mind you, it DOES NOT tell you how risky your trade is in the sense of how likely it will fail, but rather, it tells you how risky it is in the sense of how much you are willing to let go to earn that much.

How to Calculate the Risk Reward Ratio?

While placing a trade, there are a few price levels that you’ll need to be aware of:

Entry: This is the price where you buy.
Target: This is the price that you expect/hope it will reach for you to take a profit.
Stop loss: This is the price level where you decide it’s going south and it’s time to pull out from the trade.

The formula is as follows:

Risk reward ratio = (Target — Entry) / (Entry — Stop loss)

Let’s try it out!

Say, a stock has the following:

• Entry: $100

• Target: $105

• Stop loss: $97

Now, just put it in the formula below:

Risk reward ratio = (Target — Entry) / (Entry — Stop loss)

Risk reward ratio = (105–100) / (100–97)

Risk reward ratio = 1.67

Cool… so what? What does that $1.67 indicate?

It shows that for every $1 you risk; you are looking at a $1.67 gain.

Is that good or bad?

How to Determine If the Risk Reward Ratio is Good or Bad?

Well… that depends on your individual preference, but we know that some of you might not have any experience yet, so it’s hard to tell. So, here are a few common ‘rules’ that traders usually use.

If you are a risky trader, a ratio of $1 is enough for you to say yes to the trade. If you are active, but not too much of a risk-taker, a $1.5 ratio is good enough, while some people who are very profit-oriented will look at $2 as a trade worth doing.

How to trade using the Risk Reward Ratio?

The RRR acts as the final filter to tell you whether the trade is worth it. After you have looked at the chart, the patterns, the indicators, and all — if you decide that the stock might be a good trade — i.e., there is a high chance of success, the RRR will act as the tool that tells you if it’s worth the chance or not.

Like it or not, even if everything seems to go well with the indicators, like, every single indicator telling you to buy, you must entertain even the tiniest chance that it might not work out. Trading is a game of risk; you can’t escape it!

What can you do?

First, set your risk tolerance, now that will depend on your own style. How much risk are you willing to take for how much reward — we can’t decide that for you.

Say, you like to play it moderately, so $1.5 is good enough for you. Now, if you see that the ratio is below $1.5, regardless of how good the indicators are, you’re advised to just move along and look for stocks that fit your appetite.

Bottom line

The RRR is a concept used by traders to assess the potential profitability and risk associated with a trade or investment.
It quantitatively measures the relationship between the amount of money at risk (the risk) and the potential gain (the reward).
The formula is: Risk reward ratio = (Target — Entry) / (Entry — Stop loss)
Traders often look for trades with a higher potential reward compared to the risk involved.
Traders often seek a balance between risk and reward that aligns with their trading strategy and risk appetite.
If the RRR is less than 1:1, it implies that the potential loss is greater than the potential gain. This ratio is generally considered unfavorable, as it indicates that the trader stands to lose more than they can potentially gain.
The RRR does not tell you how likely is the trade to fail, but rather — if it fails, how big of a loss it will be compared to the potential gain.

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