What Is the Risk/reward (RR) ratio? How to use it in crypto trading?
Of course, no one can predict the future with 100% accuracy, and there is always some risk involved in trading cryptocurrencies. However, by using the RR ratio as a guide, you can make trades with a higher chance of success.
So, what is the RR ratio, and how can you use it in your crypto trading? Let's take a closer look.
What is the risk/reward ratio?
In finance, the risk/reward ratio measures the expected return of an investment relative to the amount of risk assumed. The higher the risk/reward ratio, the more favorable the investment is.
For example, if an investor is considering two different investments with identical expected returns but different levels of risk, they would prefer the investment with the lower level of risk.
However, if one investment has a higher expected return than another but also has a higher level of risk, the investor would prefer the investment with the higher expected return.
Investors often use the risk/reward ratio to measure the potential return of an investment relative to its level of risk. They also use it to compare different investments and determine which is more favorable based on the expected return and amount of risk involved.
When using the risk/reward ratio, it is essential to remember that past performance is not indicative of future results. Just because an investment has a high risk/reward ratio does not mean it will always be successful. Likewise, an investment with a low risk/reward ratio can still fail.
There is no magic number or perfect ratio that will guarantee success. However, the risk/reward ratio can be a helpful tool for investors when evaluating different investments.
How to compute the risk/reward ratio
The risk/reward ratio is the ratio of the potential return to the amount of risk involved. It can be expressed as a percentage or as a ratio.
To compute the risk/reward ratio, you first need to determine the expected return on the investment. You can do this by estimating the asset's future price and calculating the difference between the current price and the estimated future price.
You can then divide the expected return by the amount of risk involved. The amount of risk can be measured by the standard deviation of the returns. The higher the standard deviation, the higher the level of risk.
For example, let's say you are considering investing in Cryptocurrency A.
You believe that Cryptocurrency A will be worth €1,000 in one year. The current price of Cryptocurrency A is €500, which means your expected return is 100%.
To calculate the risk involved, you need to determine the standard deviation of the returns. If the standard deviation of the returns is 20%, there is a 95% chance that your actual return will be between +80% and +120%.
This gives us a risk/reward ratio of 100%/20%, or 5:1, which means that for every €1 you invest, you can expect to earn €5 back.
How to use the RR ratio in crypto trading
The risk/reward (RR) ratio is a tool that crypto traders can use to make better decisions about when to enter and exit trades. By understanding the RR ratio, traders can more accurately assess the potential risks and rewards before entering it.
The ideal RR ratio will vary from trader to trader, but most traders will look for trades with an RR ratio of at least 1:2. This means that for every €1 they risk, they expect to make at least €2 in return.
Some traders may even be willing to take on trades with an RR ratio of 1:3 or higher if they believe the trade has a high chance of success.
When assessing a trade's potential risk and reward, traders need to consider both the downside risk and the upside potential. The downside risk is the amount of money that could be lost if the trade goes against the trader. The upside potential is the amount of money that could be gained if the trade goes in the trader's favor.
Once a trader has determined the RR ratio of a trade, they can then decide if the trade is worth taking. If the RR ratio is 1:2 or higher, the trade may be worth taking. However, if the RR ratio is lower than 1:2, the trade may not be worth taking.
When trading cryptos, it's essential to use stop-loss orders to limit downside risk. A stop-loss order is an order that will automatically sell your position if the price falls below a certain level. Stop-loss orders can ensure that your losses are limited even if the trade goes against you.
It's also important to take profits when they're available. An excellent way to do this is to set a profit target before entering a trade. Once the price reaches your profit target, you can sell your position and take your profits.
Using the RR ratio and stop-loss orders, you can more effectively manage the risks and rewards of trading cryptos. Understanding and utilizing these tools allow you to become a more successful crypto trader.
Knowing your risk appetite
Every trader is different, and each one has its risk appetite. Some traders are willing to take on more risk to achieve greater returns, while others are more risk-averse and prefer to stick with safer investments.
Before making any trade, you must know your risk appetite. How much risk are you willing to take on? How much money are you ready to lose? By answering these questions, you can better understand the types of trades suitable for you.
Once you know your risk appetite, you can start looking for trades with an RR ratio that is in line with your risk tolerance. If you're a more risk-averse trader, you may want to look for trades with an RR ratio of 1:2 or lower. On the other hand, if you're willing to take on more risk, you may be comfortable with an RR ratio of 1:3 or higher.
Using the risk/reward ratio
It is important to remember that the RR ratio is not the only factor to consider when making a trade. Other factors are well worth thinking about, such as the time frame of the trade, your overall investment strategy, and your entry and exit points.
By considering all of these factors, you can make more informed and successful trades. And if you're unsure about a trade, you can always use automated trading tools like BOTS to help you make decisions.
This blog is for educational purposes only. The information we offer does not constitute investment advice. Please always do your own research before investing. Any views expressed in this blog and by BOTS do not constitute a recommendation that any particular cryptocurrency (or cryptocurrency token/asset/index), portfolio of cryptocurrencies, transaction, or investment strategy is suitable for any specific person.