Risk Reward Ratio in Crypto: How it Works and Why it Matters
Risk Reward Ratio in Crypto
Risk Reward Ratio in Crypto: How it Works and Why it Matters
People constantly seek to buy low and sell high in the investment world. Unfortunately, we are unable to predict an investment’s outcome in order to ensure a profit. Sometimes it can even be the complete opposite. Does that imply that there is a 50/50 chance of making money on every trade or investment?
Obviously not. It will be much simpler to navigate the stormy seas of the cryptocurrency market if you have a basic understanding of the Risk/Reward ratio.
Today, we’ll look at what the Risk/Reward Ratio in cryptocurrency trading means, and how it can be used to ensure a safe trading experience for crypto traders and investors.
What is a Risk/Reward Ratio?
The risk/reward ratio also known as RR ratio figures out how much risk a trader is taking in exchange for how much profit may be earned. To put it another way, it illustrates the possible profits for every $1 you risk on an investment.
The actual calculation is quite straightforward. You subtract your net goal profit from your maximum risk. But how do you go about that? You begin by considering where you want to start your trade. Then, if the trade is successful, you choose where to collect your winnings, and if it is unsuccessful, you choose where to place your stop-loss in the case of a losing trade.
The Risk/Reward ratio is a straightforward idea.
To fully understand it, let’s think about a practice scenario.
On a fishing boat in the middle of the ocean, you are by yourself. You see, the boat is now leaking, and the deck is being flooded. There is no raft on board for emergencies like these, so your only option for survival is a life jacket.
The first choice is to stay on the boat, and if you hold on to the accelerator tightly, there is a possibility that you will get to the seashore before the boat capsizes. The second option is to wear your life jacket and swim to the seashore.
Although you can swim reasonably well, the issue is marine predators. What if the water is filled with sharks, jellyfish, and who knows what else? Which approach is preferable?
This is when you use the Risk/Reward ratio comes to determine the best reward for the least amount of risk.
The boat is the safest option, but if you stay in it, it may sink before you reach the shore. Whereas, if you are wearing a life jacket, you stand a good chance of reaching the shore unharmed or without being bit by or eaten by a sea creature. This summarizes what the Risk/Reward ratio means.
Basic concepts concerning risk that you should know
There are a few basic concepts concerning risk that you should know regardless of whether you’re day trading or swing trading. These serve as the cornerstone of your market knowledge and provide you with a solid framework from which to operate while making trading and investment decisions. You can’t safeguard and expand your trading account if you don’t do this
If you want to effectively manage your risk, this is necessary. Before opening a trade, experienced traders establish their profit targets and stop-loss levels.
Now that you know your entry and exit criteria, you can figure out your risk/reward ratio. This is accomplished by dividing potential risk by potential profit. The ratio should be as low as possible to maximize potential profit per “unit” of risk.
Risk/Reward Ratio: How does it work?
If you frequently trade or invest for the short term, the risk factor constantly works against you. Making money through day trading could be challenging, particularly in a situation where the market can occasionally be very unstable. If you buy 10 Ethereum (ETH) at a price of $2,000 each, your total investment is $20,000. And you anticipate generating a profit of $6000 after selling the coins for $2600 each.
Let’s assume that your stop-Loss is set at $1800. In other words, your portfolio will start an automatic selling sequence if the price of one ETH tends to fall below $1800. this means other words, you are taking a $2000 net loss risk for a $6000 payoff
Applying the risk-to-reward ratio formula
Risk:Reward = 2000:6000
The loss is 10% but the profit is 30%. Consequently, in this situation, the risk to reward ratio will be 1:3. That is to say, you anticipate making three times as much profit for every unit in loss.
Reward/Risk ratios are sometimes used by traders in place of the more popular Risk/Reward ratios. Just think about how it would work if everything were reversed. A 1:3 Risk/Reward ratio will therefore become a 3:1 Reward/Risk ratio.
Now, let’s put this into practice to see how it can be set and used.
How to calculate the Risk/Reward Ratio
Imagine you want to buy bitcoin and want to open a long position. You conduct your research and come to the conclusion that your take profit order will be 15% below your entry price. You also ask the following question.
Where is your trade idea invalidated?
Setting your stop-loss order there is recommended. You decide that your invalidation point is 5% away from your entry point in this situation.
Remember that these typically shouldn’t be based on random percentage figures. Notably, these normally shouldn’t be based on arbitrary percent values. Based on your market analysis, you should choose your profit target and stop-loss levels. Indicators used in technical analysis can be extremely useful.
In this case, it is 5/15 = 1:3 = 0.33. Simple enough. This means that for each unit of risk, we’re potentially winning three times the reward. In other words, for each dollar of risk we’re taking, we’re likely to gain three. So, if we have a position worth $100, we risk losing $5 for a potential $15 profit.
We could move our stop loss closer to our entry to decrease the ratio. However, as we’ve said, entry and exit points shouldn’t be calculated based on arbitrary numbers. They should be calculated based on our analysis. If the trade setup has a high risk/reward ratio, it’s probably not worth it to try and “game” the numbers. It might be better to move on and look for a different setup with a good risk/reward ratio.
Note that positions with different sizes can have the same risk/reward ratio. For example, if we have a position worth $10,000, we risk losing $500 for a potential $1,500 profit (the ratio is still 1:3). The ratio changes only if we change the relative positions of our target and stop-loss.
Conclusion
The Risk/Reward ratio is a useful strategy for planning an investment scenario. This method, like any other trading strategy or indicator, will not be completely loss-proof. However, if used wisely, it will benefit your portfolio. In addition, ensure that you understand and thoroughly research every aspect of the market or asset to avoid unexpected events eating up your gains.
Now, if you’re interested in finding out more on how to tackle risks involved in trading and investing in Cryptocurrency, you should check out our other video about the “8 Risk management strategies when investing in Cryptocurrency”
Risk Reward Ratio in Crypto
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Disclaimer: This article is provided for informational purposes only. It is not offered or intended to be used as legal, tax, investment, financial, or other advice.
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