Risk to Reward Ratio and Win Percentage 🎖
• The risk/reward ratio is used to evaluate a trade's profit potential (reward) in relation to its possible loss (risk).
• The risk to reward ratio is calculated using a stop loss level and a target price on the stock.
• The potential profit is the difference between the target price and entry price and the potential loss is the difference between the entry price and the stop loss.
• Thus, the risk reward ratio is calculated as (Entry Price-Stop Loss)/(Target Price-Entry Price).
• The ratio primarily helps a trader to decide whether the risk is worth taking or not.
• Trades with risk/reward ratios less than 1.0 are more likely to deliver positive results than those with risk/reward ratios larger than 1.0.
• Most day traders have risk/reward ratios between 1.0 and 0.25.
• As a student with limited capital, I prefer taking trades having a ratio of 0.25 or below.
• The reason behind the same is that because I am not a so seasoned player in the market, I feel safer assuming that my win percentages will be very low.
• Win percentage simply means the number of trades in which you make money out of the total trades you take.
• When a low win to loss ratio is coupled with a low risk to reward ratio, then you can prevent the erosion of capital. Let’s take a simple example to understand this.
⭕️Case 1 : Win Percentage is 40% i.e. 4 out of 10 trades are won. Let us assume that each trade is of 1000 rupees. The risk to reward ratio is 0.25. If there are ten instances then, there will be 4 wins and 6 losses. Each win will give 4000 rupees but each loss will cost 1000 rupees.
Cumulative P/L : 4x4000 – 6X1000 = +10,000
⭕️Case 2: The win percentage remains same but now the risk to reward ratio is 1
Cumulative P/L: 4X1000 – 6x1000 = -2000
Thus, even at low win percentages, a low risk to reward ratio can help you minimise your risk and sustain in the market. ✔️
What do you feel? Do share your views!