In the world of investment, people always want to buy low and sell high. But unfortunately, we can’t foresee the outcome of investment to guarantee a profit. It can be quite the opposite at times. Does it mean every investment or trade has a 50/50 chance for profit or loss? Of course not. If you understand the concept of the Risk/Reward ratio, it’ll be way easier to steer through the choppy waters of the crypto market.Introduction to Risk/Reward Ratio
The concept of the Risk/Reward ratio is a simple one. Consider a real-life scenario to understand it better. You’re alone on a fishing boat in the middle of a river. Suddenly you see the boat is leaking, letting water pour in on the deck. It’s a one-man boat with no raft for emergency situations like this, and all you have got is a lifejacket for survival.
Now you have two options to choose from: the first one is to stay on the boat, and if you hang on to the accelerator hard, there is a chance that you can make it to the shore before the boat sinks. The other option is to put on the life jacket and swim to the shore. You’re a decent swimmer, but the problem is marine predators. What if there are sharks, snakes, and god-knows-what in the water? Which way is a better way? It is when you apply the Risk/Reward ratio to calculate the best reward against the least risk.
The boat is the safest place, but if you stay in the boat, chances are the boat will sink before reaching the shore. Whereas, with the life jacket, you have a decent chance at making it to the shore without getting bitten or eaten by something. This is the Risk/Reward ratio in a nutshell.How does the Risk/Reward ratio work?
If you’re a regular trader or short-term investor, the risk factor always plays against you. Especially in a market that can be extremely volatile at times, making a profit from day trading could be difficult. If you buy 10 ETH at the price of $2000 each, your total invested amount is $20K. And you expect to sell the coins for $2600 each, making a net profit of $6000.
Now let’s say you set your stop-Loss at $1800. In other words, if the price of one ETH tends to go below $1800, your portfolio will initiate an auto-sell sequence selling all the ETHs. So what this means is you’re risking a net loss of $2000 for a profit of $6000.
Applying the formula of risk/reward ratio:
Risk:Reward = 2000:6000
That’s 10% in a loss against 30% in profit. So the risk/reward ratio, in this case, will be 1:3. In other words, for every unit in loss, you expect three times the amount in profit.
Some traders use the Reward/Risk ratio as opposed to the more common Risk/Reward ratio. The function is the same; just consider everything in reverse. So a 1:3 Risk/Reward ratio will be a 3:1 Reward/Risk ratio.Risk Appetite in Risk/Reward Ratio
The Risk/Reward ratio is one of the most popular indicators used to calculate the potency of a stock or cryptocurrency. If you know how much risk you can afford to take, choosing 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. Take a look at the chart below.
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.Closing Thoughts
The Risk/Reward ratio is a useful strategy to map out an investment scenario. Like every trading strategy and indicator, this won’t be a 100% loss-proof method. But using it wisely will positively affect your portfolio. However, make sure you understand and deeply research every aspect of the market or the asset to prevent any unforeseen circumstances from eating up your gains.
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