In investing and trading it is fairly easy to grasp how to define reward. it’s the money that we expect to earn from our trading. The profit can be derived from either a change in value of the product we trade (e.g. buy low trade high) or through the earnings generated from investing (e.g. the payment of dividends or interest).
What Is Risk?
There is the chance of not getting the result you’d like to see. The share price may not increase like you expected or that the company’s expected dividends will be cut or eliminated altogether.
In investing and trading the risk of loss can be classified into a variety of types according to the source. Examples:
- Liquidity Risk is the chance that you’ll be unable to trade into and out of the position you wish to trade in;
- Market Risk is the chance that the entire market will fall in value while you own an investment
- Correlation Risk The risk that all your investments decline in value simultaneously;
- The risk of currency This is the case when you purchase an asset in a different currency than your own.
- The risk of interest rate The risk that interest rates may alter and could have an adverse impact for your investments.
- The risk of inflation The risk of a shift in rate of inflation will reduce or even eliminate your anticipated return.
- The risk of political instability The risk associated with an event of a political nature (an election or coup. ) or a political decision (e.g. new legislation) adversely affecting your investment.
Risk classification as described above is beneficial because it allows you to often hedge or insure against risk specific to. For instance, you can purchase shares in Tesla and in the process, purchase Forex derivatives to guard against a drop in the value of the USD. You could also purchase shares of Shell and simultaneously reduce the oil price to safeguard you from any possibility of a decline in oil’s price will adversely affect Shell’s share price.
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There are a myriad of ways professionals in the field of risk try to quantify and measure risk.
A simple and easy method to evaluate the level of risk is to look at three factors that can be considered:
- The variety of possible possibilities for
- The odds of each one of these outcomes
- The probability of positive outcomes in comparison to. the chance of negative outcomes
Let’s examine the first one possibilities, the variety of possible results.
Do you prefer to bet all your money on the tossing of the coin or on your capacity to determine the next number after you toss a six-sided dice? If you choose to bet on the coin, you stand one in two (50 percent) possibility of winning. If you choose to bet on the dice, your odds are one in six (16.67 percent) which means that it is likely that you decided to place your bets with the chance of a coin flip.
All else being equally, the more potential outcomes exist the more likely the outcome.
But this is only true if probability of throwing a head is equal to the likelihood of tossing the tail, and the likelihood of rolling any of the six numbers on die is exactly the same.
What happens if I give you a die weighted to ensure that a 6 is rolled about 80 percent times out of the year? There are six possibilities but one (rolling six) is more likely to occur than the other possibilities combined.
Therefore, it is important to consider the likelihood of each outcome occurring. This is the second thing we need to consider.
The third option is to consider how many possible outcomes could be beneficial for you, and then add the probabilities of each, and then multiply the odds of negative results. The higher this second number is in comparison to one, the more risky the scenario.
In the previous example when you use the loaded die and a betting amount of 6 will result in the possibility of losing and 80percent of winning. This type of comparison will give you a better understanding of the risk you’re taking on. Of course, this is only an example that illustrates how to go about measuring risk. However, there’s much more to investing and trading more than flipping coins or rolling a dice.
The Relationship Between Risk and Reward
Once we know more about reward and risk as distinct concepts, we can examine the connection between them.
It’s a fact in the realm of finance: when you are looking to earn more rewards, you need to be prepared to take on more risk. It is the opposite in the case of trading investments, the more risky your investment, the more rewards you’ll have to offer investors in order to convince the decision to take the risk.
Imagine that you are an investor and are offered two investment options both A and B. Both of them offer the same potential for return, but you consider that investment A is twice as risky than investment B. Which would you pick? The majority of people would go with B.
If this occurs throughout the entire market, the prices of these investments will adjust in line with the fact that riskier investments generally offer better rewards.
In general there is a gradual progression between the listed assets of higher risk and greater anticipated reward:
- Loans for short-term duration also known as bond of financially healthy government;
- Obligations or loans with a long-term term duration from government that are economically sound;
- Bonds or loans of economically healthy businesses;
- Obligations or loans from higher risk (high-yield) firms;
The above list isn’t complete and there are gaps between the ranges for every asset category. For instance stocks of a major established supermarket chain could be considered safer than bonds issued by some high yielding companies.
The relation between reward and risk is an important concept in the field of finance.
What Is the Risk Reward Ratio?
To make it easier to understand all of these points, many investors employ the risk-reward ratio. The name itself suggests that it is a measure that evaluates the potential for loss (risk) against the highest possible profit (reward).
In order to use the risk-reward ratio for a specific trade, the trader will put a stop-loss or stop-splash order in place that will reduce the possibility of loss from the trade. Then, they put in a take-profit trade to secure profits once a certain amount has been achieved.
How Is it Calculated?
If you know that the trader is at risk of losing the maximum amount and a potential maximum profit it is easy to contrast one with the other.
As an example, suppose you decide to purchase Apple shares for $135 per share. If you also place an order for a stop loss of $130 and a profit-taking order at $160. Our maximum risk (or chance) is $5/share, and your maximum possible profit is $25 per share which gives you the ratio 5:25 or 1:5.
Depicted: Admiral Markets MetaTrader 5 – Apple Inc. Weekly Chart. Date Range: 17 May 2015 – 4 February 2021. Date Captured: 4 February 2021. Past performance isn’t necessarily an indicator of the future performance.
Usefulness and Limitations
The most disciplined investors and traders usually set the goal of achieving a certain risk reward ratio and then use it to analyze potential positions in the market. This is an effective instrument to reduce the possibility of losing money in trades.
But, just because you established a target 1:1 risk-to-reward ratio for each trade, it doesn’t mean you’re likely to earn PS3 for each PS1 loss. This is because merely applying a strategy with an extremely high risk reward ratio doesn’t tell you any information about the likelihood of the price of the market reaching or even exceeding the limit that the stop-loss is or the amount that the profit-taking limit is.
What Is A Good Risk to Reward?
There is no easy answer to this question. The optimal risk-to-reward ratio can vary based on the specific situation as well as your preferred style of trading ( scalping, day trading, day and so on. ) and your willingness to take on risk and other variables.
The most efficient method of using the risk-reward ratio is to determine both factors independent of each other and in accordance with your own personal analysis, whether it’s fundamental analysis or technical analysis or both.
When you determine the risk-reward proportion, then you could utilize it to objectively compare the possible trades. You could also establish the standard, such as that you will not make trades that have a less than 1:1 risk-reward ratio. These are great ways to begin your risk-reward analysis.
If you’ve learned more about the risk-reward ratio, make sure to include it in your investment and trading strategies. It’s an effective and easy way to enhance the effectiveness of your control of risk.