Has anyone know what is the best way to calculate risk to rewards ration?
The profit to risk ratio is used by traders to compare potential profits with potential losses. To calculate the profit to risk ratio, divide the possible profit from a trade by the amount you stand to lose if your position is closed at the stop loss level.
The most commonly used profit to risk ratio values are 2:1, 3:1 and 4:1. These ratios will depend on the trading strategy you adopt. Although there are many factors that affect the risk of a trade (market volatility or capital management strategy), a fixed profit/risk ratio can determine your long-term success.
Suppose we decide to take a long position in the stock of company ABC. We buy 100 lots, which are equivalent to 100 shares at USD 20 each. The value of the entire position is USD 2000 . We assume that the value of these shares will increase in the near future to 30 USD. The price level at which we conclude that we would like to limit losses is 15 USD. Stop loss at this level will ensure that our potential losses should not exceed 500 USD.
In our example, we are willing to risk USD 5 per share to receive an expected return of USD 10. Since we risked funds that are half of the potential profit, our profit/risk ratio is 2:1. If our target was US 15 per share, our ratio would be 3:1. Maintaining such a profit/risk ratio means that one profitable transaction can cover two or three losses.
It should be remembered, however, that although the profit/risk ratio helps us manage probability, it does not give us information regarding the probability of the transaction's success itself.
The risk/reward ratio is obtained by comparing the potential loss (in pips, in monetary units or percentages) with the potential profit. These values can be defined, for example, in Stop Loss and Take Profit orders. Although the use of the risk/reward ratio/ratio is quite natural and theoretically does not cause any problems to anyone, there are, however, several problematic issues. I would like to describe two that, in my opinion, most often concern traders with little experience on the market (but not only). The first one is purely formal and mainly related to communication. The second one is related to understanding the nature of risk and the relationship between average profits and losses and the percentage of profitable and losing trades.
Using the risk/reward relationship often creates problems in communication. The most common errors here are two. The first is when we say, for example, that we are using a risk-reward ratio of 5:1, thinking of a situation in which our potential profit is five times greater than the potential loss. A 5:1 ratio means that this risk is five times greater than the potential gain, and we most often make the mistake here of presenting a risk to gain ratio rather than a risk to gain ratio.