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Risk Reward Ratio – A Complete Guide for Beginners

The ability to manage risks effectively is the key to success in trading. A well-established risk management strategy helps minimize losses. The way to fine-tune an effective risk management system, one needs to understand the risk-reward ratio of every trade. It makes it possible to better decide on the steps and configurations while pursuing maximum net profit.

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In this guide, you will learn more about the concept of the risk-reward ratio in trading. We will discuss how to use it when managing trading risks.

Why Is It Important to Manage Risks in Trading?

The idea of trading is not just about winning every trade you can. It requires specific skills used to minimize losses and manage risks. So, the more successful you are at keeping losses low, the more experienced and skillful a trader you are.

It gives you a chance not just to win a trade but also to boost net profit making your strategies more effective from the revenue perspective. Meanwhile, the average losses are smaller.

What Is Risk-Reward Ratio?

The risk-reward ratio defines the investor’s ability to stand profit for every cent he or she risks on each trade. In simpler words, the ratio is used to measure potential rewards and risks for every order. As a result, you have enough data to have an objective comparison of each potential trade and configure your strategies accordingly.

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For example, a 1:1 risk-reward ratio means that you can potentially lose as much as you can gain. Not quite a good outcome, isn’t it? That is why the majority of traders target a risk-reward ratio of 1:3 or higher. It means that winning chances are three times higher than the probability of losing.

Risk-Reward Ratio Calculation

To make necessary risk-reward ratio calculations, you are supposed to know three major factors:

  1. The entry price.
  2. The price you target.
  3. A stop loss.

The difference between the entry price and stop loss is equal to the amount you are going to lose if the trade stops out. Oppositely, the difference between the target price and the entry price is equal to your potential reward. It is the amount you will get as a profit if everything goes smoothly following the plan.

How to Trade with Risk-Reward Ratio in Mind

When you use the risk-reward ratio as a part of your strategies, you need to consider several important factors:

  1. Try to keep your risk-reward realistic.
  2. Use as accurate a ratio as possible.
  3. Determine a stop loss and target price first.
  4. Use a 1:3 or higher risk-reward ratio.

Tips to Analyze Risk-Reward Ratio like a Pro

It is not the only factor to consider. If you want to ensure a positive outcome for every trade, you need to take into account other crucial factors. A win rate is one of them going hand-in-hand with risk-reward.

The idea is to have the right balance between these two factors. Some newbies mistakenly think that a successful trader has at least 80% of a winning rate. It is a common delusion. In reality, you may have a win rate of only40% and still gain success. All you need is to know how to manage risks using technical indicators such as support and resistance levels.

The following tips may come in handy:

  • Set the target price based on resistance levels and other technical indicators.
  • Place the stop-loss below the support level.
  • Always analyze your previous trades. Explore how they evolved or failed to take into account your previous price target and stop-loss orders.
  • Keep your risk-reward ratio as meaningful as possible and always stick to the trading plan.
  • As stated earlier, try to keep your trading approach as realistic as possible. For example, if you place a stop loss at $164 per Apple share with a risk-reward ratio of 1:15, it is very likely that your trade will stop out before it reaches the price target. Also, take into account volatility when setting a stop-loss order.

Traders must always think of the amount of cash they are risking. They need to compare it with the current risk-reward ratio and decide on the optimal position size. So, the key to success is to select the size of the position that makes you feel comfortable in the context of potential gains and losses.

The Bottom Line

The risk-reward ratio is a tool to maintain an objective measurement of how much you can gain or lose with each trade. The instrument can be used to compare different trading approaches and configure them accordingly. What’s more, the ratio helps to run an effective risk-management strategy and set realistic trading goals.

To trade with a risk-reward ratio successfully, you need to select a proper position size as well as use technical indicators to determine the appropriate target price and stop loss. Another crucial tip here is to put all emotions aside and trade following the plan whatever happens.

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.