The risk/reward ratio or risk/reward ratio is a commonly used metric in trading that compares the potential profit from a trade to the potential loss. This means that it is the reward that traders will spend for the risk they take.
For example, an investment with a 1:3 risk/reward ratio would mean that for every dollar an investor spends, they will get back three dollars if the trade goes in their favor. The risk-reward ratio is critical to cryptocurrency trading, whether it’s day trading or long-term cryptocurrency investment, known as “hodling.”
To better understand, let’s look at it in context cryptocurrency trading.
How to calculate the risk/reward ratio
Assuming that the prevailing price of Ether (ETH) is $2,000, the crypto trader may choose to enter a long position (buy) with the following parameters:
Entry fee: $2,000
The price at which they buy ETH.
Stop-loss: $1,800
Should the price of ETH fall, which is not in favor of the trader, stop-loss point is where they would sell their earned ETH (for a loss) and avoid further losses. In other words, they are risking $200 per ETH purchased for $2,000.
Take profit: $3,000
If the price of ETH rises, the take profit price is the point where they would sell the ETH, which in this case would be at a profit of $1000, a reward of $1000 per ETH.
There are plenty of risk-reward calculators available online for cryptocurrency trading. The above example shows how to manually calculate the risk-reward ratio:
- The initial risk is $200 per ETH (the distance between the entry price of $2,000 and the stop-loss price of $1,800).
- The take-profit level offers a reward of $1,000 per ETH, giving a risk-reward ratio of 1:5 ($200 risk divided by $1,000 reward).
Here is the formula for the risk/reward ratio:
Related: What is a business journal and how to use it
What are the pros, cons, and cons of the risk-reward ratio?
The risk-reward ratio helps traders evaluate the potential risks and rewards of a trade and make decisions accordingly. It allows traders to effectively manage risk by setting stop-loss orders and take-profit levels, thereby limiting potential losses while maximizing profits.
However, the risk-reward ratio is a risk management measure and does not guarantee trading success because:
- It is based on assumptions about the future price movement of the asset, which may not always be true.
- It may be overly simplistic and may not take into account other important factors such as market conditions, liquidity and transaction costs.
For example, if the market suddenly becomes highly volatile (high price swings), the trader may need to constantly adjust stop-losses or take-profit levels. And the crypto market is known to generate volatility.
After calculating the risk/reward ratio, the trader should evaluate whether it suits his trading strategy and risk tolerance. This means that you cannot rely solely on the risk-reward ratio when trading cryptocurrencies. Traders should use it with other risk management strategies, trading plans and discipline to succeed.
How to optimize the risk/reward ratio?
What is considered a good risk/reward ratio? While 1:2 is considered a practical and optimal risk-reward ratio in crypto (as in traditional trading), there are no fixed rules for its use, with the ratio depending on traders’ expectations and strategy.
Achieving the optimal risk-reward ratio requires balancing the potential risk and return of a trade, which depends on risk tolerance and trading strategy. The risk-reward ratio can accompany several metrics or allow traders to optimize it.
Here’s how to use the risk-reward ratio for cryptocurrency trading:
Position size
Position size is not necessarily a measure or metric; it is the amount of capital (cryptoasset capital) allocated to each trade. Position sizing is a critical part of a trading risk management strategy. It helps to control the potential losses and profits of the trade.
The size of the position directly affects the risk/reward ratio, i.e. a larger position size can increase the potential profit of the trade and the possible loss. Conversely, a smaller position size can limit potential profits and losses.
Win rate
The win rate is a percentage of the total number of profitable trades to the total number of trades, which measures how often a trader’s trades are profitable. A high win rate means the trader is consistently making profitable trades and doesn’t have to rely as much on big winning trades. Accordingly, the trader can afford to use a lower and safer risk/reward ratio, which can still be profitable because the trader wins more often.
On the other hand, a lower win rate means the trader has to rely more on big winning trades to make money and face volatility risks associated with a higher risk-reward ratio.
Maximum Drawdown (MDD)
Maximum drawdown is a fundamental metric that traders must consider when assessing the risk/reward ratio of their trades. It is the largest percentage drop a trader sees in their trading account from its highest value prior to the start of the drop. It measures the largest amount of money a trader has lost in their account from their highest value before it started going downhill. So how does max draw affect the risk/reward ratio?
Let’s assume that the trader has a risk/reward ratio of 1:2, meaning that he risks $1 to make a profit of $2. Further, imagine that the maximum draw of the trading strategy is 50%. In such a case, the trader could potentially lose half of their trading account before the strategy turns around and becomes profitable again.
Even if the risk-reward ratio is favorable, the overall risk of the strategy may be too high. One way to get around this is to use a tight stop-loss to avoid potentially losing the maximum drawdown. However, this translates into a lower risk/reward ratio.
It’s about finding the right balance between managing maximum drawdown risk and maintaining a favorable risk/reward ratio.
Expectation
Expectations measure the probability of making a profit in the long run from a series of trades or investments. It measures the long-term profitability of a business or investment strategy. Positive anticipation is more or less like the ultimate goal of all business initiatives.
Similar to the win rate, the loss rate is the loss percentage. Average win and loss sizes are the average profits and losses from a series of trades or investments.
The risk-reward ratio plays a vital role in determining the expected duration. A high risk-to-reward ratio means that potential gains are more significant than potential losses. This means that if a trader wins 33% of his trades with, say, a 1:2 risk-to-reward ratio, his average win is twice as large as his average loss, which in turn means higher expectations. Conversely, for a low risk/reward ratio, traders would need more wins (win rate).
What factors should be considered when determining the risk/reward ratio of cryptocurrency trading?
Cryptocurrency trading is often influenced by several factors and traders take risks in order to achieve the desired profits. Here are a few:
Crypto market volatility
If there’s one thing the cryptocurrency ecosystem is infamous for — aside from hacks and pullers — it’s how unstable its trading scene is. Set the risk/reward ratio with careful consideration.
Liquidity
in simple words, liquidity refers to reserves, tokens, or groups of tokens that are readily available for exchange. This means the ability to buy and sell assets quickly and easily. The low liquidity of cryptoassets can increase the risk of trading and make it difficult to realize profits.
The power of core technology
What a trading token stands for, the problem it solves and its growth potential, greatly affects the risk of trading it. The more well-known and established a token is, the lower the risk of trading it.
Regulatory landscape
The cryptocurrency world has a long way to go when it comes to the regulations that jurisdictions create around it. And every new (or updated) law directly affects business sentiment.
Related: What is Profit and Loss (PnL) and how to calculate it
How important is the risk-reward ratio when trading cryptocurrencies?
Just as a seesaw balances two opposing forces, the risk and reward of an investment opportunity must be carefully balanced. The risk-reward ratio requires constant adjustment and vigilance to maintain balance and avoid the pitfalls of either extreme.
As detailed in this article, there are many ways to optimize it and several factors that affect it. While this is an important metric, it is not a holy grail solution that guarantees success in any cryptocurrency trading strategy. Understand and experiment with how it plays into the larger ensemble business strategy and risk management.
