In the world of trading, people always want to buy low and sell high. But unfortunately, no one can predict the outcome of investment to ensure a profit. It can be quite the opposite at times. It does not mean that every investment or trade has a chance of 50/50 profit or loss. If you clearly understand the concept of the Risk/Reward ratio, it will be much easier to navigate the stormy waters of the crypto market.
Introduction to Risk/Reward Ratio
The concept of the Risk/Reward ratio is quite simple. Let us consider a real-life situation to understand it thoroughly. Assume that You’re alone on a fishing boat in the middle of a river. Suddenly you find that the boat is leaking, and letting water pour in on the deck. It’s a one-man boat with no raft for emergencies like this, and all you have is just a lifejacket for survival.
Now in this situation, you are left with only two options: the first one is to stay on the boat, and if you fasten on to the accelerator hard, there is a probability that you can make it to the shore before the boat sinks. The second option is to put on the life jacket & swim to the shore. You’re an average swimmer, but the difficulty is marine predators. What if there are aquatic animals like sharks, sea snakes, and god-knows-what in the water? Which way is a better way? It is the situation when you apply the Risk/Reward ratio to calculate the best reward against the least risk.
The boat is the most safest place, but if you choose to stay in the boat, there are chances that the boat will sink before reaching the shore. Whereas, with the life jacket, you have a chance of making it to the shore without being bitten or eaten by something. This is the Risk/Reward ratio in a nutshell.
How does the Risk/Reward ratio work?
If you’re in the field of investing and are a regular trader or short-term investor, the risk factor always plays against you. Especially in a market that can be extremely volatile, making a profit from day trading could be challenging. If you buy 5 ETH at the price of $1000 each, your total invested amount is $10K. And you expect to sell the coins for $2000 each, making a net profit of $10000.
Now let’s say you set your stop-Loss at $800. In other words, if the price of one ETH tends to go below $800, your portfolio will initiate an auto-sell sequence selling all the ETHs. So what this means is you’re risking a net loss of $1000 for a profit of $10000.
Applying the formula of risk/reward ratio:
Risk:Reward = 1000:10000
Instead of the more conventional Risk/Reward ratio, some traders utilize the Reward/Risk ratio. The function is the same; just think about it backward. i.e. a 1:3 Risk/Reward ratio becomes a 3:1 Risk/Reward ratio.
Risk Appetite in Risk/Reward Ratio
The Risk/Reward ratio is one of the most traditional indicators used to estimate the worth of a stock or cryptocurrency. If you know how much risk you can afford, it would be easier to choose the right crypto, and trading strategy will be easier. But there is one mistake many beginners and even intermediate-level traders tend to make when calculating the Risk/Reward ratio. It has a low-risk appetite. Having a risk-averse mindset is a good strategy, but if you want to get the best profit from your crypto investment, you have to cut some slack on risks.
If you invested in BTC in June 2021 when the price was around $40K and set your stop-loss at $30K, you would have surely lost money in July. But if your stop-loss was at $25K or below, you could have realized a profit when BTC crossed $49K in the fourth week of August.
To play the risk/reward ratio:
Let’s say you bought 1 BTC at $40K and intended to sell it at $50K. And you set your stop loss at $30K. Even with a 1:1 Risk/Reward ratio, you would have lost money because your risk appetite was too low. Whenever you’re planning to invest in a market, always take the volatility into account.