The return on risk (R/R) ratio has been one of the most effective trading tools. In crypto trading, this ratio assists investors in minimizing risk and maximizing reward.
What is the risk to return ratio?
The risk/return factor is utilized to gauge the prospective growth and decline of every deal by applying input cost, stop loss and take profit orders. So there are two primary instruments that you want to ensure that the risk/profit factor is working: stop loss and take profit.
A stop loss can be set to exit a trade if it is against your position. For instance, if an investor goes into a long Bitcoin position at $50,000 and places a stop loss at 4%, they will automatically get out of the deal at $48,000.
If the goal return is 20% while the entry cost was $50,000, take profit will automatically exit the deal at $60,000.
What is a decent risk/return balance?
The risk/profit balance may be computed with formulas, but the key concept is simply this: you go into a deal where the reward potential is greater than the risk of loss. A risk/profit ratio is 1:5, which means that you only put one dollar at risk but can gain as much as five dollars, is seen as optimum by many crypto traders and is commonly listed as «0.3» in the calculations formulas.
The risk/return indicator can be as low or as high as 0.3, but a bigger risk reduces the odds of return to a minimum, while a lower risk doesn’t always yield acceptable gains. The highest ratio of risk to return must be 0.5. At this balance, you have more odds of making a return.
What makes risk/profit important
The risk/profit balance is the easiest and most useful trading metric because it allows you to mathematically evaluate the potential advantages and disadvantages of each trade. It is more important than the «win ratio» (the percentage of successful deals compared to losing transactions) because it can be applicable to every trade, irrespective of trading record.
Even if the winning ratio is 80% (eight out of ten deals are winning), one failed trade can be disastrous. Relying on R/R estimates, it is possible to minimum trade risk and place a stop loss that will compensate for the first loss. This allows making a profit even with a lower win ratio.
It isn’t necessary to always utilize stop loss and take profit in deals, but estimating the risk /profit allows the trader to understand what their prospects are. For instance, the R/R may be 1:3 when the take profit for a Bitcoin deal is fixed at $45,000, but you can remove the take profit and allow it to rise to $50,000, resulting in an even larger profit.
Pro traders compute the risk/return of every deal because they are putting a large amount of equity at risk. When you go into a deal worth more than one million dollars, in case the trade doesn’t go as planned, you set a stop loss that will prevent you from losing your capital. However, traders trading as few as $1,000 will also benefit from this tool.
How to compute the risk/profit balance for crypto deals
For calculating the risk/profit balance in a crypto deal, it is necessary to have an indicator in the form of a basic «input cost». The input cost is the value of the cryptocurrency at the time you go into the deal. For instance, it can be $45,000 for BTC or $2380 for ETH. Calculations are made based on the base price.
«Risk» in the R/R ratio refers to the maximum loss that can be incurred in a trade. «Reward» is the profit you will make after the deal hits a particular price.
Take profit can be set 50% or even 200% higher than the input cost. Using leverage multiplies profitability but also increases the potential for losses.
R/R calculation equation
The R/R correlation is computed by splitting the risk by the reward. You can perform the calculation for each deal utilizing a basic formula:
(Input cost - Stop loss)/(Take profit - Input cost) = Risk/profit correlation.
This is how to implement this equation for Bitcoin trading:
Input cost: $60,000
Stop loss: $57,000
Take profit: $66,000
Computation: (60,000 - 57,000)/(66,000 - 60,000) = 3,000/6,000 = 0.5
This deal has an R/R correlation of 0.5. To ensure that your deals remain consistently profitable, you should aim for an R/R ratio in the range of 0.3-0.5.
The same computation can also be used for the ETH deal:
Input cost: $3,500
Stop loss: $3,150
Take profit: $4,200
Computation: (3,500 - 3,150)/(4,200 - 3,500) = 350/700 = 0.3
This is one more ETH deal with R/R correlation equal to 1 (same risk/profit):
Input cost: $3,500
Stop loss: $3,150
Take profit: $3,850
Computation: (3,500 - 3,150)/(3,850 - 3,500) = 350/350 = 1
The 2nd ETH deal is lower risk compared to the 1st ETH deal, as take profit is placed at $3,850, which ETH is more likely to reach before the price rises to $4,200. But the upside potential is also minimized.
Only three scenarios are possible: risk over return, return over risk, and risk equals return. If the R/R ratio is greater than 1, you may get a smaller reward than the amount you risk to lose.
Stop loss and take profit in computing the risk/profit balance
Utilizing R/R only makes a lot of sense if you are using trading instruments such as stop loss and take profit. The R/R computation can as well assist you in calculating the profit needed to compensate for capital loss.
As mentioned earlier, if you were to lose 90% of equity in a single trade, you would need a 900% return on the remaining 10% to recover your original equity. Assuming you only lose 5% of equity (having set a stop loss), you would only require a 5.26% return on the remaining 95% balance to recover your initial loss.
How effective is the use of the R/R ratio in cryptocurrency trading?
The R/R balance is utilized for both trading stocks and cryptocurrencies. But R/R multiples are a lot more robust for stock markets as they are less susceptible to any price fluctuation.
The market cap of cryptocurrencies is smaller than the market capitalization of Forex or gold, and this makes them prone to sudden price swings caused by various factors. For example, these could be the operations of «whales» who own large cryptocurrency reserves. Bitcoin whales exert wave impact on the marketplaces, particularly on miners that are selling their tokens. Altcoins are often influenced by Bitcoin’s behavior.
In crypto markets, price swings of major cryptocurrencies are typically 10-20% daily. Crypto investors must be careful of news from the world of cryptocurrencies, which can trigger rapid price increases or decreases. If you trade ETH or other alternative cryptocurrencies, you need to focus on the BTC price.
The point is that you can’t just depend on the R/R pattern and need to monitor the events on the digital markets. Let’s pretend that you’ve computed a comparatively low-risk BTC deal with an R/R of 0.3. While the trade seems potentially successful, suddenly news comes out that Tesla is no more taking Bitcoins or that China has banned all cryptocurrencies causing the markets to crash.
Opinion
The risk-to-return (R/R) correlation provides a gauge of the level of risk that can be taken in exchange for a certain level of profit. In an ideal trade, the potential profit exceeds the risk. If you have an R/R ratio of 0.3, that means you will get $3 for each dollar that you risk. For the majority of deals, a risk factor as low as 0.5 is advisable.
To help make deals profitable, begin by computing your risk/return correlation utilizing the techniques presented in this tutorial and applying them to your trading. Utilizing stop loss triggers will help you prevent unsustainable risk levels, and take profit will allow you to automatically cash out at a certain point in the trade.
