What Is the Risk/Reward Ratio and How to Use It?

July 19, 2021

Reading Time: 4 minutes

The crypto industry, though upcoming, is lately flexing its potential, factoring in the fundamentals of similar fields. These fields that crypto has primarily borrowed from include forex trading, stock markets, and the banking sector. For instance, forex trading and stock trading command understanding of trading signals through the use of standard ratios such as the risk-reward ratio.

The applicability of the risk-reward ratio in crypto trading is quite similar to forex and stock trading. The risk-reward ratio in crypto trading also has the same fundamental function as forex and stock trading. This function rewards the crypto trader with the highest potential profit from trades while minimizing the potential risks or losses resulting from trading.

Defining Risk Reward Ratio (R/R)

The risk-reward ratio measures a crypto trade’s potential profit in a market uptrend to its possible loss in case of a market downtrend. The possible loss from trade is its risk, whereas the trade’s potential profit is its reward.

The risk-reward ratio in cryptocurrency trading is a crucial tool today, and swing traders enter positions upon monitoring erratic daily market movements. Generally, a 1:3 or greater risk-reward ratio is usually favorable for crypto traders to enter meaningful trades. This 1:3 risk reward ratio implies that the trade will likely have three times the potential reward for every 1 unit of additional risk undertaken.

How to Calculate the Risk-Reward Ratio

The risk-reward ratio in cryptocurrency trading is calculated by dividing the difference between the trade entry point and the stop-loss order by the difference between the profit target and the entry point.

R/R= (Entry Point – Stop-Loss Order) ÷ (Profit Target – Entry Point)

To better understand the risk-reward ratio formula above, we dive into the definitions of its components:

  • Entry point- The current market price where a crypto trader buys or sells crypto.
  • Stop-loss order- An automatic order to sell if a cryptocurrency falls to a certain amount.
  • Profit target- The projected price at which a crypto trader is willing to sell crypto.

The crypto trader is solely responsible for individually determining these components of the risk-reward formula before trading.

Now, let’s look at a real case example of the risk reward formula in use. Suppose crypto trader X wants to trade some Bitcoin and sets the entry point at $45,000, stop-loss order at $40, 000, and has a profit target of $60,000, the risk reward ratio will be:

R/R = ($45,000 – $40,000) ÷ ($60,000 – $45,000)

= 1:3 or 0.3

The potential reward for this trade is three times the risk associated with it, making this a lucrative trade to undertake. Also, the trade is worthwhile since the risk-reward ratio is below 1. Crypto experts generally consider trades with risk-reward ratios above one to be very risky.

How to Use the Risk-Reward Ratio

The risk-reward use case above illustrates how to calculate the risk-reward ratio without laying concrete and helpful applications for crypto traders. In this subsection, we will delve into calculating Bitcoin’s risk-reward ratio as per the price chart below:

Source: Coin Insider

This chart represents the prevailing market prices of BTC at this particular point in time.  A crypto trader wants to determine the best entry point plus other parameters to get a favorable risk-reward ratio to realize maximum profit. The green line represents the price target. The white line represents the entry point, whereas the red dotted line represents the stop-loss order.

This trader enters a long position at the point where the market seems to start recovering, that is, at $11500. He sets the stop-loss order at $10 562.85 and the profit target at $13000, as shown in the chart above. If BTC value falls to, say, $9000, no further loss of investment will occur due to the trigger of the stop-loss order. Instead, the trader’s BTC holdings will automatically sell once the value reaches the $10562.85 stop-loss mark.

The risk-reward ratio in this trade will be:

R/R = ($11, 500– $10, 562.85) ÷ ($13, 000 – $11, 500)

= 3/5 or 0.625

Bitcoin’s risk-reward ratio, in this case, implies that for every potential risk of $3, the trader’s potential reward is $5. Also, the risk-reward ratio is lower than 1, making this trade worthwhile.

Limitations of the Risk-Reward Ratio

The risk-reward ratio is generally helpful in crypto trading. It founds the basis of sound crypto trading, which does not follow unnecessary hype, a common vice in crypto trading. Despite its efficiency in delivering high-profit gains to tactful crypto traders, the risk-reward ratio has its fair share of disadvantages, including:

  • Applying the risk-reward ratio in a bearish market is not suitable since traders may completely lose investments.
  • Failure to set a stop-loss may lead to loss of investment in a bullish market due to market correction or the start of a bear run.
  • Applying the risk-reward ratio in crypto trading alone can have adverse outcomes since various trading indicators work in harmony to produce the best combination of a trading route to undertake. An example of these indicators is the win ratio which indicates the degree of success of a crypto trader.

Conclusion

The risk-reward ratio is a vital investment indicator in crypto trading circles, especially in day and swing trading strategies. The risk-reward indicator compliments technical trading by analyzing crypto charts to determine suitable entry and exit points in a trade, as well as the reasonable stop-loss order for a particular trade. In this way, potential gains from a crypto trade are maximized while minimizing the potential losses.

For more educative articles on crypto, visit mycryptoparadise.com.

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