Calculating Risk And Reward: Minimizing Loss In Trading

## What is risk/reward in trading?

By definition, risk/reward calculation equals the potential of profits divided by net risks. Traders determine the amount of risk, although partially influencing the profit level. In layman’s terms, the higher the risk, the higher the rewards and vice versa. Traders affect trading by the lines they set at the beginning of a trade. Going by the layman’s definition: the more the traders wish to acquire (profits), the easier it is to lose money (high potential risk). One way traders reduce loss is setting a stop-loss: automatically stopping the loss before it devalues totally. Stop-loss is active whenever the system automatically makes a sale, especially when security drops beyond the value range.

Risk is the safe route and total price you have between the entry point of trade and stop loss order. For better understanding, picture trade with a mission where you need plans: plan A and plan B. Plan A is the existing plan where you trade and maximize profits (manually), then exit the trade with minimum loss (maximum profit). However, all trade does not follow plan A; thus, you need a plan B. Plan B is the stop-loss. Stop loss helps you stop “loss” before it devalues your “values” beyond measures.

### What is the risk/reward ratio?

Simply put, the risk/reward ratio shows the number of rewards you potentially have on every \$ you risk in a trade. Remember that all trade comes with potential risks and rewards: the level or balance between the two factors shows the amount of money remaining after a single trade. A trade requires planning; one of the plans is figuring risk/reward ratio. All traders use risk/reward ratios to know the expected rewards in each trade while they are very aware of the risk involved. The risk/reward ensures you put an effective stop-loss and plan A (as mentioned above).

For example, a risk/reward ratio is 1:5 if a trader risks \$1 to earn a potential \$5. Remember that the ratio does not reflect the starting price; it shows the percentage of the remaining money after a trade. If the ratio moves in the positive direction as the trader predicted, the trade comes with rewards; otherwise, it is considered a loss.

### Understanding risk/reward ratio

Assuming a trader buys a stock at \$30 in a WWW company and puts stop-loss at \$25. However, the trader predicts that the stock price should increase to \$40 in a couple of weeks from the time of purchase. According to the above illustration, the trader is willing to risk a \$5 loss for a \$ 10 gain: a 1:2 risk/reward ratio. Alternatively, if another trader buys at \$30 but puts stop-loss at \$20 but predicts that the price would also be at \$40 in a few weeks. Then, the risk/reward ratio is 1:1 – meaning that the trader risk a \$10 loss for a \$10 profit.

In the above illustration, although the traders target the same profits, they trigger their stop-loss at a different point. Stop-loss plays an important role in trade; it differs per trader’s decision, prediction, and analysis.

### How to calculate the risk/reward ratio?

Again, the risk is the potential profit at the end of a trade; the reward is the potential loss at the end of a trade. Both risk and reward are analyzed based on the stop loss. The three main factors in calculating the risk/reward ratio are the stop loss, entry point, and profit target.

The formula is:

### How the Risk/Reward Ratio Works

What is the value of the risk compared to the profit? This is what the risk/reward ratio tells you. It is important to understand why you practice an action – why must you engage in a trade, and what will you have in return? The risk/reward ratio allows you to see what you do wrong or are about to do wrong. 1.0 ratio is the ideal value for placing risk and reward in a trade.

A high-risk trade has a risk/reward ratio above 1.0 and vice versa. The risk/reward shows why you should not engage in a high-risk trade. What if the trade does not work out? You need a better plan if you will at least engage at the end of the day. Why would you engage in high-risk trading when you can channel the energy to finding more suitable trades with less risk? – these are the questions the risk/reward ratio asks you.

With a risk/reward ratio, you should know the next step after trading, aside from the risk involved in the trade. Trading includes “trading emotions.” You can channel your energy to withstand the emotional stress and high tension during a trade if you already know the amount of risk involved. For example, you may quickly end a trade if you put your stop-loss at a value that cannot secure more profit but loss. Since you clearly understand the risk/reward ratio you are working with, you may improvise (manually) before the stop-loss.

The risk/reward ratio works by telling you not to place the stop-loss at a random place. Why do you understand the calculation and trading risk if you would not utilize it for safe trading? Simply put, risk/reward exists so that you can prepare for the worse. If risks were absent in trading, risk/reward would be absent – the presence of risk/reward is a measure that fights against trade loss. How you utilize it determines how well you can cope with profits.

For effective trading, the stop-loss, entry point, and profit target must be logical. Working with effectiveness comes with logical factors of risk/reward. Lastly, the risk/reward ratio tells you never to gamble!

## Using the Risk/Reward Calculation

Utilizing the risk/reward calculation demands setting proper stop-loss, rewards, and risk-reward analysis.

### How to set proper stop-loss: limiting risk and stop losses

People do say “anything could happen;” the saying is evident in trading. Even though you put a stop-loss, slippage may affect you. Slippage is when the expected price is different from the actual price. Many things cause slippage; it affects your price value even in the presence of stop-loss.

For example, consider a stop-loss at \$19.5, a \$20 entry price, and a slippage of \$0.05. It means the trader expects \$19.5 (with a loss of \$4.5) but actually receives \$19 (with a loss of \$5). Why? Slippage happens!

It will help if you plan for slippage while setting a stop-loss. Well, you may not accurately predict slippage; however, working with market orders gives you an upper and effective save out. A market order is a type of stop-loss. It is a stop-loss order at the current value (in price) when the security is sold out or when exchanges happen. Devaluation and increase in currency values affect the market orders. You may end a trade before it reaches the stop-loss if you predict a slippage or see it happening.

Unlike market order, the limit order closes a trade at stop-loss when the amount (in price) equals the assigned stop-loss (value). Note that the market order stops at any price (once it reaches the stop-loss). However, a limit order stop-loss continues until the stop-loss has the same value (in price) as the stop-loss or even better. Limit order stop-loss is a better option if the value equals the stop-loss; however, it works against you if the loss continues (without an equal price–value ratio)

Again, consider a stop-loss at \$19.5, a \$20 entry price, and a slippage of \$0.05. It means the trader expects \$19.5 (with a loss of \$4.5) but actually receives \$19 (with a loss of \$5). At this point, if the trader sets the market order stop-loss, the trade stops, and a trader has a slippage loss. However, the trade will not stop until the price equals \$19.5 in value, in the case of limit order stop-loss.”

Working with a stop-loss, that is, choosing between market order stop-loss and limit order stop-loss,” is a strategic game that requires total practice.

Buying is a game of “profit or loss.” So, you want to be active and know the “swing low.” Swing low is a term that describes a fall and rise in price. You should set stop-loss a little below the swing low since it can bounce back to the normal price. Stop-loss permit fluctuations; however, it ensures your safety during a drastic loss. It will help if you trade in the trend’s direction since fluctuations are permitted with safety: the swing low should rise as you buy.

Setting stop-loss order when short selling

The swing low finds support at the low price, while the swing high finds support at the high price. Thus, you should put a stop-loss a little above the “swing high.” The stop-loss allows fluctuations in short selling, just like buying, increasing the resistance at the upper price level.

You do not have to follow the ideas here

A trading strategy is not static: what works for you may not work for others. So, you do not have to follow the idea here; you can decide to place your stop-loss order at any point. The only thing you must have considered is your strategy, indicator, and others. It will help if you are grounded to predict the next step, especially how you will put a stop-loss order.

Bottom line

Strategy, by definition, is how you make things happen. However, the way you execute a strategy differs per individual. “How you make things happen” in trading involves expertise, information, and resources. Even though risk and reward calculation demands strategy, how you sustain and minimize loss is a mind game. Lastly, total safety is not assured in trading, and the current profits do not mean a net profit. Therefore, do all it takes to close a trade with gain!