The risk/reward ratio or risk/return ratio is a commonly used metric in trading that compares the potential profit of a trade with the potential loss. That said, it’s the reward traders stand to make for the risk they take.
For example, an investment with a risk/reward ratio of 1:3 would mean that for every dollar the investor spends, they gain three dollars if the trading goes in their favor. The risk/reward ratio is decisive to cryptocurrency trading, whether for daily trades or crypto investment for the long run, known as “hodling.”
To gain a better understanding, let’s consider it in the context of crypto trading.
How to calculate the risk/reward ratio
Assuming that the prevailing price of Ether (ETH) is $2,000, a crypto trader might decide to enter a long position (buy) with the following parameters:
Entry price: $2,000
The price at which they purchase ETH.
Should the price of ETH go down, which is not in the trader’s favor, the stop-loss point is where they would sell the ETH acquired (for a loss) and avoid further losses. In other words, they’re risking $200 per ETH bought at $2000.
Take profit: $3,000
If the price of ETH goes up, the take profit price is the point they would sell the ETH, which, in this case, would be for a profit of $1000, a reward of $1000 per ETH.
Plenty of risk/reward ratio calculators are available online for cryptocurrency trading. Using the above example, here’s 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, which gives 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 trading journal, and how to use one
What are the pros, cons, buts and howevers of the risk/reward ratio?
The risk/reward ratio helps traders evaluate a trade’s potential risks and rewards, and make decisions accordingly. It allows traders to manage risk effectively by setting stop-loss orders and take-profit levels, limiting potential losses while maximizing profits.
However, the risk/reward ratio is a measure for managing risk and does not guarantee success in trading because:
- It is based on assumptions about an asset’s future price movement, which may not always hold.
- It can be oversimplified and may not consider other important factors, such as market conditions, liquidity and transaction costs.
For example, if the market suddenly becomes highly volatile (high price fluctuations), a trader may need to keep adjusting stop-loss or take profit levels. And the crypto market is known to breed volatility.
After calculating the risk/reward ratio, the trader should evaluate whether it suits their trading strategy and risk tolerance. That said, one cannot rely solely on the risk/reward ratio for cryptocurrency trading. 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 regarded as a practical and optimal risk/reward ratio in crypto (as well as traditional trading), there are no fixed rules for its use, with the ratio depending on the traders’ expectations and strategy.
Arriving at the optimal risk/reward ratio requires balancing a trade’s potential risk and reward, which depends on risk tolerance and trading strategy. Several metrics can accompany the risk/reward ratio or enable traders to optimize it.
Here’s how to use the risk/reward ratio for crypto trading:
The position size is not necessarily a measure or metric; it’s the amount of capital (crypto asset capital) allocated to each trade. Determining the position size is a critical component of trading risk management strategy. It helps to control potential losses and profits of a trade.
The position size directly impacts the risk/reward ratio, i.e., a larger position size can increase a trade’s potential profit and the possible loss. Conversely, a smaller position size may limit the potential profit and loss.
The win rate is the percentage of the total number of profitable trades to the total trades, measuring how often a trader’s trades are profitable. A high win rate means the trader consistently makes profitable trades and doesn’t need to rely as heavily 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 is winning more often.
On the other hand, a lower win rate means that the trader needs to rely more on big winning trades to make money and face the volatility risks associated with a more significant risk/reward ratio.
Maximum drawdown (MDD)
Maximum drawdown is an essential metric for traders to consider when assessing their trades’ risk/reward ratio. It is the biggest percentage drop a trader sees in their trading account from its highest value before the decline started. It measures the largest amount of money a trader lost in their account from its highest value before things started going downhill. So how does maximum drawdown influence the risk/reward ratio?
Suppose a trader has a risk/reward ratio of 1:2, meaning they risk $1 to potentially make a profit of $2. Furthermore, imagine the maximum drawdown of the trading strategy is 50%. In that case, the trader could potentially lose half of their trading account before the strategy turns around and becomes profitable again.
As such, even though the risk/reward ratio is favorable, the strategy’s overall risk may be too high. One way around this is to use a narrow stop-loss and avoid the potential loss of the maximum drawdown. However, this translates to a lesser risk/reward ratio.
It’s about finding the right balance between managing the maximum drawdown risk and maintaining a favorable risk/reward ratio.
Expectancy measures the likelihood of making a profit over the long term on a series of trades or investments. It measures the long-term profitability of a trading or investing strategy. Positive expectancy is more or less like the ultimate objective of all trading initiatives.
Akin to the win rate, the loss rate is the unprofitable percentage. The average win and loss sizes are the average profits and losses on a series of trades or investments.
The risk/reward ratio plays a critical role in determining expectancy. A high risk/reward ratio means that potential profits are more considerable than potential losses. This means that if a trader wins 33% of their trades with, say, a 1:2 risk-reward ratio, their average win is twice as large as the average loss, which, in turn, translates to higher expectancy. Conversely, for a low risk/reward ratio, traders would need more wins (win rate).
What factors should be considered while determining the risk/reward ratio in cryptocurrency trading?
Several factors often influence cryptocurrency trading and the risk traders will take to hit the desired profits. Here are a few:
Crypto market volatility
If there is one thing the cryptocurrency ecosystem is infamous for — apart from the hacks and rug pulls — it is how volatile its trading scene is. Set risk/reward ratio with careful consideration.
In simple words, liquidity refers to reserves, tokens or token pools readily available for exchange. It translates to the ability to buy and sell assets quickly and easily. Low liquidity of a crypto asset can increase the risk of trading and make it more challenging to realize profits.
Strength of underlying technology
What the trading token stands for, i.e., the problem it solves and the potential of its growth, greatly influences the risk of trading with it. The more reputed and established the token, the lower the risk of trading with it.
The cryptocurrency world has a long way to go regarding the regulations jurisdictions create around it. And each new (or updated) law directly impacts trading sentiment.
Related: What is profit and loss (PnL) and how to calculate it
How important is the risk/reward ratio in cryptocurrency trading?
Just as a seesaw balances two opposing forces, the risk and reward of an investment opportunity must also be carefully balanced. The risk/reward ratio requires constant adjustments 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 influencing it. While it is an important metric, it is not a holy grail solution that guarantees success in any crypto trading strategy. Understand and experiment with how it plays into the broader set of trading strategies and risk management.