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Investing Guide: How Should You Analyse Risk/Reward?

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October 26th, 2021 21:24

Analyse risk/reward and stay stress-free

The question that needs to be answered first here is “Why should you analyse risk/reward? And what benefits will it give you?” If you are investing somewhere, then the right research and future analysis should be done. These traits are part of a good investor profile. Am I right?

Individuals without being aware of the risk levels, enter the market and suffer badly. 

When making investments in real estate or stock markets, profit and loss targets must be made clear in your mind, in order for you to not be too greedy or fall into a trap that will be hard to overcome. 

Be it large or small investments, investors will expect leveled profits

You can analyse your risk/reward ratio by simply dividing the net profit by the price of maximum risk. There are many factors other than this which are involved in the risk management process.

So, how should you analyse risk/reward to make a proper assessment of your personal risk?

You can start by selecting stocks you want to invest in after conducting extensive research. Set your highest and lowest hit targets according to the current price. Go ahead and use the risk/reward ratio calculation by the above-mentioned formula.

If the answer hits below your lowest target, try to make it work with an acceptable ratio. And if that cannot be done, then choose some other investment idea. 

You might have to go through tons of charts to find a stock that lies perfectly in your risk/reward ratio analysis. Extensive research brings confidence, and these calculations can help you make more money.

What is the risk/reward ratio?

Risk/reward ratio = Distance from your entry to stop-loss/your profit order

For instance, the distance between entry and stop-loss is 100 and your profit is 200.

So, that makes your risk/reward ratio (RRR) 1:2

In trading charts, you can do the same for risk/reward ratio calculation. Just select the risk/reward tool on the left-side toolbar and mark your entry, stop-loss, and profit targets set.

New investors often have certain perceptions when considering a good or bad risk/reward ratio. However, there is no such thing as good or bad when it comes to risk/reward; it is all about the analysis.

You must combine the risk/reward ratio with the winning rate and accordingly make judgments, not just on the basis of risk/reward ratio outcome. With this combination, you will know whether or not you will make money in the long run.

If your win rate turns out to be more than 50%, then you will be able to make profits.

News

Even if your RRR and win rates are working fine and you are confident about long-term profits, any news or incidents can change any stock drastically. 

News can turn the entire share market upside down at any moment. So, it is advised to be frequently checking your investments. Moreover, do read about the companies you invest in from time to time.

Stop-loss

Study moving averages, define your entry with support and resistance levels, and draw possible trend lines. If the market is in the down-trend, in long and short positions, you must score profits at resistance and support. Don’t make your stop-loss too tight as this could affect your trade. 

If you want your research and analysis to work well, then you can put a stop-loss at a point where trading chart patterns undergo major changes according to you. There should be enough room to move the risk/reward ratio to 1:1. 

If you achieve that, then you can go further with the trade. This can be compared to playing poker where we take little risks until we are sure of our moves.

To analyse risk/reward, do not aim for specific set numbers in your mind as it might put you in trouble. As exact target hits do not happen often, try to exit a bit earlier to safeguard your investments.

Trade with the trend to avoid risks and mark stop-loss every time you do so. You can never predict the market 100% right as it is.

Conclusion

Investors and traders should know that neither a high win rate nor a greater risk/reward ratio will make money for you. A combination of both with a lot of news learning and research will help in generating good returns.  

Frequently asked questions

1. How do you analyse risk/reward?

  • Calculate risk/reward and divide the net profit (reward) by the price of your maximum risk. Do this for every investment. 

2. What is a good risk/reward ratio?

  • Market strategists find the good risk/reward ratio (RRR) for their investments to be three units of expected return for every one unit of additional risk. Investors can manage RRR more directly through the use of stop-loss orders and derivatives such as put options.

3. What are the main reasons why most traders fail?

  • The two biggest reasons are lack of knowledge and not placing a stop-loss on every order they make. The market volatility is beyond control and these mistakes make them face huge losses. 

4. How much should I risk per trade?

  • Risk per trade should always be a small percentage of your total capital. A good starting percentage could be 2% of your available trading capital.

5. What percentage of traders are successful?

  • This might be shocking but yes, only six percent of the people who attempt to become professional traders actually succeed.




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