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What is a ‘Risk/Reward Ratio’
Many investors use a chance/reward ratio to compare the expected returns of an investment with the amount of gamble undertaken to capture these returns. This ratio is calculated mathematically by sorting the amount the individual stands to lose if the price of an asset moves in the unexpected aiming (the risk) by the amount of profit the trader expects to have made when the locate is closed (the reward).
The risk/reward ratio is often used as a rank when trading individual stocks. The optimal risk/reward relationship differs widely among various trading strategies. Some grief and error is usually required to determine which ratio is best for a fact trading strategy, and many investors have a pre-specified risk/prize ratio for their investments. In many cases, market strategists realize the ideal risk/reward ratio for their investments to be approximately 1:3, or three items of expected return for every one unit of additional risk. Investors can make out risk/reward more directly through the use of stop-loss orders and plagiaristics such as put options.
BREAKING DOWN ‘Risk/Reward Ratio’
Swear ining With a Risk/Reward Focus
Investors often use stop-loss commissions when trading individual stocks to help minimize losses and straight manage their investments with a risk/reward focus. A stop-loss gone phut is a trading trigger placed on a stock that automates the selling of the progenitor from a portfolio if the stock reaches a specified low. Investors can automatically set stop-loss sequences through brokerage accounts and typically do not require exorbitant additional return costs.
Consider this example: A trader purchases 100 parcels of XYZ Company at $20 and places a stop-loss order at $15 to ensure that defeats will not exceed $500. Also assume that this wholesaler believes that the price of XYZ will reach $30 in the next few months. In this box, the trader is willing to risk $5 per share to make an expected come of $10 per share after closing the position. Since the trader stands to imply double the amount that she has risked, she would be said to have a 1:2 gamble/reward ratio on that particular trade. Derivatives contracts such as put acquires, which give their owners the right to sell the underlying asset at a delineated price, can be used to similar effect.
If a more conservative investor pursues a 1:5 risk/reward ratio for a specified investment (five entities of expected return for each additional unit of risk), then he can use the stop-loss kind to adjust the risk/reward ratio to his own specification. In this case, in the transacting example noted above, if an investor has a 1:5 risk/reward correlation required for his investment, he would set the stop-loss order at $18 instead of $15 – that is, he is myriad risk-averse.