Best Risk Reward Ratio For Day Trading: Before you take a trade, one thing you must make sure of is that you have a good risk/reward ratio. Without a good risk/reward ratio, it’s very hard for a trader to be profitable consistently.
It’s very important that any strategy that is implemented in the market, has a good risk-reward ratio in place. In this article, we will understand what a risk/reward ratio is and how it works and what is a good risk/reward ratio for trading.
What Is The Risk/Reward Ratio?
The risk/reward ratio, sometimes known as the R/R ratio, is a measure that compares the potential profit of trade to its potential loss. It is calculated by dividing the difference between the entry point of a trade and the stop-loss order (the risk) by the difference between the profit target and the entry point (the reward).
R/R Ratio = (Entry Price – Stop Loss Price) ⁄ (Target Price – Entry Price)
The risk/reward ratio is used to assess the profit potential (reward) of a trade relative to its potential loss (risk). Both the risk and reward of trade are based on the discretion of the trader.
How Does The Risk/Reward Ratio Work?
When figuring out the risk/reward for a trade, place the stop-loss at a logical place. Then, place a logical profit target based on your strategy and analysis.
These levels should not be randomly chosen. After doing this analysis, we can enter in a logical decision of whether to enter into that particular trade or not.
Day traders, swing traders, and investors should shy away from trades where the profit potential is less than what they are putting at risk. This is indicated by a risk/reward greater than 1.0.
There are enough favourable opportunities available that there is little reason to take on more risk for less profit.
What Is A Good Risk/Reward Ratio?
A good risk/reward ratio is very subjective and will depend on your trading style, the strategy you use, your risk appetite, and the security you are trading. What matters is the strategy that you are using should be in sync with your risk/reward ratio.
If a strategy makes you money 7 out of 10 times or 8 out of 10 times then a risk/reward ratio of 1:1 will be enough for you to be profitable. In another case, if a strategy makes you money 3 out of 10 times or 4 out of 10 times then your risk/reward ratio will need to be much higher, around 1:7 or 1:8 for you to be profitable.
In the table given below are the risk/reward ratios and win-loss percentages you would need for being profitable.
Let’s take an example from the table that is given above. Let’s assume that your strategy has a risk/reward of 1:1. You enter the trade when the price is at Rs 100 with a stop-loss at Rs 95 and your target is at Rs 105.
For you to be breakeven your strategy would have to work 5 out of 10 times and for you to be profitable your strategy would have to work 6 out of 10 times.
To effectively use the risk/reward ratio, you need a trading plan that establishes:
• Acceptable market conditions.
• When and where to enter a trade.
• Where to place your stop-loss and profit targets under those market conditions.
Limitations Of The Risk/Reward Ratio
A low risk/reward ratio does not tell you everything you need to know about trade. You also need to know the likelihood of reaching those targets.
The risk/reward ratio is not always precise and the trader must make a judgment based on his or her risk tolerance and specific price movement expectations.
Choosing the best risk/reward ratios is a balancing act between taking trades that offer more profit than risk while ensuring that the trade still has a reasonable chance of reaching the target before the stop loss.
Also Read: What Is A Good PE Ratio In Indian Stock Market?
The risk/reward ratio should not be the only measure you use to establish whether a trade is a good risk or not.
It is often used with other risk-management ratios, such as the win/loss ratio, which compares the number of winning and losing trades, and the break-even percentage, which gives the number of winning trades that are necessary to break even.
That’s all for the post on Best Risk Reward Ratio For Day Trading, We hope you enjoyed reading it. Happy Investing!
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