Risk / Reward is a common term in financial vernacular, but what does it mean? Simply put, investing money into the markets has a high degree of risk, and you should be compensated if you’re going to take that risk.
The risk reward ratio measures how much your potential reward is, for every rupee you risk.
For example: If you have a risk reward ratio of 3:1, it means you’re risking Rs. 1 to potentially make Rs. 3.
If you have a risk reward ratio of 5:1 , it means you’re risking Rs. 1 to potentially make Rs. 5.
CALCULATION OF RISK REWARD RATIO
If XYZ stock is trading at Rs. 25, down from a recent high of Rs. 29. You believe that if you buy now, in the not-so-distant future, XYZ will go back up to Rs. 29, and you can cash in. You have Rs. 500 to put toward this investment, so you buy 20 shares.
The calculation of risk/reward is very easy. You simply divide your net profit (the reward) by the price of your maximum risk. Using the XYZ example above, if your stock went up to Rs. 29 per share, you would make Rs. 4 for each of your 20 shares for a total of Rs. 80. You paid Rs. 500 for it, so you would divide 80 by 500 which gives you 0.16. That means that your risk/reward for this idea is 0.16:1. Most professional investors won’t give the idea a second look at such a low risk/reward ratio, so this is a terrible idea.
Every good investor has a stop-loss, or a price on the downside that limits their risk. If you set a Rs. 29 sell limit price as the upside, maybe you set Rs. 20 as the maximum downside. Once your stop-loss order reaches Rs. 20, you sell it and look for the next opportunity. Because we limited our downside, we can now change our numbers a bit. Your new profit stays the same at Rs. 80, but your risk is now only Rs. 100 (Rs. 5 maximum loss multiplied by the 20 shares that you own), or 80/100 = 0.8:1. This is still not ideal.
What if we raised our stop-loss price to Rs. 23, risking only Rs. 2 per share or Rs. 40 loss in total? Remember, 80/40 is 2:1, which is acceptable. Note : 2:1 is considered the minimum by most.
Of course, you have to decide for yourself what the acceptable ratio is for you.
To incorporate risk/reward calculations into your research, follow these steps:
- Pick a stock using exhaustive research.
- Set the upside and downside targets based on the current price.
- Calculate the risk/reward.
- If it is below your threshold, raise your downside target to attempt to achieve an acceptable ratio. (min 2 : 1)
- If you can’t achieve an acceptable ratio, start over with a different investment idea.
The most favourable investment comes when we comb through hundreds of charts each day looking for ideas that fit their risk/reward profile. Don’t shy away from this. The more meticulous you are, the better your chances of making money.
If the risk/reward becomes unfavorable, don’t be afraid to exit the trade. Never find yourself in a situation where the risk/reward ratio isn’t in your favor.
Dilzer Consultants Pvt Ltd