What is a Risk/Reward Ratio
Many investors use a risk/reward ratio to compare the expected returns of an investment with the amount of risk undertaken to capture these returns. This ratio is calculated mathematically by dividing the amount the individual stands to lose if the price of an asset 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).
The risk/reward ratio is often used as a measure when trading individual stocks. The optimal risk/reward ratio differs widely among various 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 pre-specified risk/reward ratio for their investments. In many cases, market strategists find the ideal risk/reward ratio for their investments to be approximately 1:3, or three units of expected return for every one unit of additional risk. Investors can manage risk/reward more directly through the use of stop-loss orders and derivatives such as put options.
BREAKING DOWN Risk/Reward Ratio
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. Derivatives contracts such as put contracts, which give their owners the right to sell the underlying asset at a specified price, can be used to similar effect.
If a more conservative investor seeks a 1:5 risk/reward ratio for a specified investment (five units of expected return for each additional unit of risk), then he can use the stop-loss order to adjust the risk/reward ratio to his own 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 instead of $15 - that is, he is more risk-averse.