Risk-Reward Ratio Explained

There is a great variety of instruments that help investors make finance choices. One of the popular ones is the risk-reward ratio – it enables them to see if purchasing a certain asset is a sound idea. It can be very helpful, but at the same time, it is not perfect, so those who deal with the investments should get acquainted with its pros and cons. We are going to take a detailed look at this tool and its calculation.

The risk-reward ratio explained

This ratio, also called the risk-to-reward ratio, acts as a special metric that serves investors who want to evaluate the profit they might get of an investment relative to the accompanying risk. Here is the formula to calculate the ratio: 

Potential reward divided by potential risk.

The higher the ratio, the more profit investors anticipate. Moving forward, we will delve into a more specific example.

How to calculate the risk-reward ratio

Let us see how this tool would work for a hypothetical crypto investment. 

• Cryptocurrency’s price (also the entry point): $500 per token 
• Target price: $600 per token 
• Maximum tolerable loss: $450 per token 
• Number of tokens: 10 

Calculations:  

• Profit per token = $600 - $500 = $100 per token 
• Total anticipated profit = Profit per token * Number of tokens = $100 * 10 = $1,000 
• Potential risk: Potential loss per token = Entry price - Maximum tolerable loss = $500 - $450 = $50 per token 
• Total potential loss = Potential loss per token * Number of tokens = $50 * 10 = $500 
• Risk-Reward Ratio = Reward / Risk = $1,000 / $500 = 2 

In this situation, the established risk-to-reward ratio stands at 2, signifying that for the anticipated reward of $2, $1 is at stake. This configuration looks like an advantageous profile that may attract a trader's attention.

Risk management tools are a must with any crypto trade. For instance, in the situation we have described above, a stop-loss order at $450 per token can be implemented to prevent losses.

At the same time, we have to acknowledge that various factors, such as market conditions, crypto volatility, and relevant news, can exert a significant influence on outcomes. This is why investors should be prepared to change their strategies whenever it is necessary.

The significance of the risk-reward ratio

The importance of the ratio for cryptocurrency investors manifests in several dimensions.

Risk management

The risk to reward ratio provides a rather comprehensive framework that helps investors with decision-making. It aids in understanding risks and their assessment, which leads to creating efficient strategies. By setting risk levels based on this ratio in advance, investors become more disciplined and have more chances to avoid impulsive reactions to market changes. Consequently, this tool becomes an integral part of a well-established risk management plan, generally bolstering the security of one’s approach to investments.

Realistic expectations

When it comes to cryptocurrency investments, the risk-reward ratio plays an important role in cultivating realistic views on what an investor might expect. By assigning a numerical value to the gains and losses, this ratio offers a clear indicator for seeing how viable the trade is. In a way, it turns into a rational anchor and prevents unreasonable purchases and selling of crypto driven by market sentiment or short-term fluctuations. Moreover, this gives investors a ground to discuss their expectations from a particular asset’s performance in the future and see whether their estimations hold up against the ideas of others, helping them establish realistic views.

Portfolio optimization

To optimize a cryptocurrency portfolio, investors have to evaluate the risk-to-reward ratios of their assets thoroughly and systematically. Doing so enables them to allocate resources for a balanced and diversified portfolio according to their preferences. In other words, examining risk-reward ratio gives them the understanding about the overall risk exposure and helps managing it with regard to their financial goals. Therefore, the risk-to-reward ratio is a great tool for optimizing asset allocation. Beyond theoretical considerations, optimizing one’s portfolio is a practical and useful action grounded in quantitative assessment.

Performance evaluation

Over time, the risk-reward ratio becomes a valuable tool for estimating the performance of the cryptocurrency trades and investments done in the past. By looking at the historical ratios, investors get insights into the effectiveness of their decision-making and risk management strategies. Looking back at the patterns, strengths, and weaknesses in using risk-to-reward ratio gives valuable feedback, helping investors with refining their overall approach. This continuous improvement is what can ultimately lead crypto investors to finding a winning strategy and successfully adapting to changing market conditions.

Adaptation to market conditions

Thanks to the dynamic nature of the ratio, it is a great tool for navigating the ever-changing market landscapes. Influenced by numerous variables, the economic conditions change, and this is especially true for the highly volatile crypto market. Because the risk-reward ratio can be easily adjusted, it has the flexibility that is necessary in such conditions. As a result, it becomes possible to respond proactively to the changes. 

Communication and transparency

The ratio can be a powerful communication tool for crypto professionals and advisors, fostering transparency with clients. By figuring it out for a particular asset and then presenting it to the clients, they might help them with understanding the potential risks and rewards better. The transparency also empowers clients to communicate their risk tolerance and financial goals in a clear form enhancing their interaction with the advisors. This shared understanding strengthens the advisor-client relationship, emphasizing the dynamics of risk and return at play.

Limitations of the risk-reward ratio

Even though all the benefits we have listed above are making the crypto investors’ lives easier, we still have to outline the fact that the risk-reward ratio is not perfect. Here are some of the factors that should be taken into consideration.

• Simplified viewpoint. The fact that the tool exclusively focuses on risks and rewards may result in oversight of other important points, such as diverse market dynamics, volatility, and other influential factors affecting outcomes.
• Limited probability assessment. The tool does not incorporate a probability assessment of success or failure. This means that it offers a restricted understanding of how likely the given outcomes are.
• Disregarding transaction costs. The risk-reward ratio does not take into account the commissions and fees that come with trading, however, those can have a big significance for the traders.
• Possible overtrading. Too much of an emphasis on just the ratio might influence traders to go with unreasonable risks, potentially leading to overtrading.
• Subjectivity. Using risk-reward ratio implies individual analyses which introduces a subjective element to it, leading to variations in perceived risk-reward ratios among traders.

Alternatives to the risk-reward ratio

While the cons of the method do not inherently label the tool as flawed, using it with caution is essential. To optimize its effectiveness and ensure a positive impact, consider integrating the risk-reward ratio with various other widely embraced investment instruments. Here are several alternatives.

• Sharpe ratio. It measures the risk-adjusted return of an investment, taking into account both total return and volatility in relation to the risk-free rate. A higher Sharpe ratio means a better risk-adjusted performance.
• Sortino ratio. This metric focuses specifically on downside risk in its measurement of risk-adjusted returns. By pointing out the volatility of negative returns, this ratio offers a more targeted overview of investment risk, making it particularly valuable for those investors who prioritize the protection of their portfolios from potential losses.
• Volatility measures. Volatility measures, such as standard deviation, present an alternative perspective to the risk-reward ratio by taking a look at the extent of price variation in a trading instrument. Lower volatility is often associated with lower risk, providing investors with insights into the stability and potential fluctuations of an investment's price.
• Fundamental analysis. Measuring the intrinsic value of a security by examining factors such as financial statements, economic indicators, and industry trends gives investors a qualitative understanding of an asset's value, unlike the purely quantitative nature of the risk-reward ratio.
• Moving averages. Using this metric smoothes out price data to identify trends over a specified period. Traders often use moving averages alongside the risk-reward ratio to confirm trend direction and identify potential entry or exit points in the market, offering a complementary tool for assessing market dynamics.
• Relative Strength Index (RSI). It serves as an alternative to the risk-reward ratio in technical analysis by measuring the speed and change of price movements. When combined with the risk-reward ratio, RSI helps traders to identify overbought or oversold conditions, providing additional insights for decision-making in the context of potential price reversals.

What constitutes a good risk-reward ratio?

Finding a “good” risk-reward ratio is something that investors should do for themselves because it is influenced by their risk tolerance, investment strategy, and the market conditions. However, in this section, we are mentioning some of the general principles that are usually taken into account.

• Above 1 to 1. Such a ratio implies that the potential rewards and potential risks are equal or that rewards outweigh the potential risks.
• 2 to 1 or more. This says that for each dollar at risk, there is the potential to gain at least two dollars. 
• Adaptability. A good risk-reward ratio can adapt to the dynamic shifts in market conditions. Traders have to keep in mind that it might become necessary to adjust their risk-reward parameters in response to the ever-evolving dynamics of the market.

To conclude, risk-reward ratio is a rather easy-to-use yet effective tool for crypto investors. While it has many benefits, there are a few downsides, such as subjectivity, potential for overtrading, and others. This is why traders should use several tools to make sure that their calculations are correct.

SimpleSwap reminds you that this article is provided for informational purposes only and does not provide investment advice. All purchases and cryptocurrency investments are your own responsibility.