What is a 'Risk/Reward Ratio'
Many investors use a risk/reward ratio to compare the expected returns of an investment to the amount of risk undertaken to capture these returns. This ratio is calculated mathematically by dividing the amount the trader stands to lose if the price moves in the unexpected direction (the risk) by the amount of profit the trader expects to have made when the position is closed (the reward).
BREAKING DOWN 'Risk/Reward Ratio'The risk/reward ratio is most often used as a measure for trading individual stocks. The optimal risk/reward ratio differs widely among trading strategies. Some trial and error is usually required to determine which ratio is best for a given trading strategy, and many investors have a specified risk/reward ratio for their investments. In many cases, market strategists find the ideal risk/reward ratio for their investments to be 1:3. Investors can manage risk/reward more directly through the use of stop-loss orders and derivatives.
Investing With a Risk/Reward Focus
Investors often use stop-loss orders when trading individual stocks to help minimize losses and directly manage their investments with a risk/reward focus. A stop-loss order is a trading trigger placed on a stock that automates the selling of the stock from a portfolio if the stock reaches a specified low. Investors can automatically set stop-loss orders through brokerage accounts and typically do not require exorbitant additional trading costs.
Consider this example. A trader purchases 100 shares of XYZ Company at $20 and places a stop-loss order at $15 to ensure that losses will not exceed $500. Also assume that this trader believes that the price of XYZ will reach $30 in the next few months. In this case, the trader is willing to risk $5 per share to make an expected return of $10 per share after closing the position. Since the trader stands to make double the amount that she has risked, she would be said to have a 1:2 risk/reward ratio on that particular trade.
Using the Risk/Reward Ratio to Your Advantage
Investing with a risk/reward focus for individual stocks using stop-loss orders can significantly help investors to manage the overall risk on their investments. Stop-loss orders allow investors to place a sell trigger on their investments at essentially only the trading cost of the block trade. With this trading mechanism in place, investors can manipulate risk/reward ratios to their benefit by setting a specified risk/reward ratio of their choosing per investment.
For example, if a conservative investor seeks a 1:5 risk/reward ratio for a specified investment, then he can use the stop-loss order to adjust the risk/reward ratio to his investing specification. In this case, in the trading example noted above, if an investor has a 1:5 risk/reward ratio required for his investment, he would set the stop-loss order at $18.