In any form of investment, there are primarily two parameters which an investor needs to look at before coming to a sound decision. These two parameters are:`
Every form of investment, especially in the stock market, incorporates a risk factor and does not come with a guaranteed return, no matter how safe an investment sound. Therefore, an investor always needs to access the risk before putting his money on stake. Although depending upon numerous variables, the degree of risk may vary from one investment opportunity to another.
Another parameter is the potential reward that an investor expects out of his investment. The potential reward also varies with many factors and generally goes hand in hand with the risk. This means lower the risk; lower would be the potential reward and vice versa.
While making an informed investment decision, an investor needs to look at both the risk and reward to spot investment opportunities that match his/her risk profile and also satisfies his return expectations.
This comparison of risk with the reward through a mathematical calculation is called Risk to Reward ratio.
First, one needs to determine the risk and the reward quantitively in order to calculate the Risk to Reward ratio. There are many ways to determine these two parameters using technical analysis, fundamental analysis or any other method.
Let's assume the determined risk is $100, and the reward is $200. Now dividing risk with reward gives the ratio between the two.
In our example, it would be $100 (risk) /$200 (reward) = ½ or 1:2. The is interpreted as $1 of risk is needed to be taken in order to make $2.
Higher the Risk to Reward ratio, better would be the investment/trading opportunity.
Let's assume an investor B has two investment opportunities and wants to invest in any one of them. He may use the Risk to Reward ratio as a parameter to qualify an opportunity for his investment.
Investment opportunity – 1
An investor B is looking at a company’s share price, which is trading at $100. After his extensive analysis, he determines the intrinsic value of the company’s shares comes at $160. That’s an upside potential of $60 from the current market price of $100. Now, the reward of $60 per share ($160 - $100) has been determined.
He also assumes that there are chances that the stock might drop to $70 instead of moving up. Therefore, he pre-determines his decision to exit the stock below $70 (if it drops) as he is not willing to take more risk than $30 per share. With this decision, he has capped his max risk to $30 per share ($100 - $70).
Combining both the parameters, B is willing to risk $30 ($100 - $70) in order to make a potential profit of $60 ($160 - $100). That gives him the Risk to Reward ratio of 1:2, which means, he is willing to risk $1 for making a potential profit of $2.
Investment opportunity - 2
The same investor B has another company in mind which is trading at $200, and his analysis states an intrinsic value of the company’s shares at $230. In case the stock does not move as expected and turns towards south, B decides to hold till $140 and not below that.
If the stock moves in favour of B, he can make a profit of $30 per share ($230 – $200). However, if the stock falls, against the expectations, then B will book the loss of $60 per share ($200 - $140). Combining both the parameters, B is willing to lose $60 per share in order to make only $30 per share, giving him a risk to reward ratio of 1:0.5. This means he is ready to earn only $1 for every $2 of risk.
Comparing both the investment opportunities together, it is evident that investment in the 1st opportunity is a sound decision than going for the 2nd option.
In the 1st opportunity, if B loses his money, he would be losing only $30 per share but would make $60 per share if he is right. In the 2nd option, B will lose $60 per share if his analysis goes wrong but would be making only $30 per share if the stock moves as expected.
In order to succeed in the stock market, apart from high risk to reward ratio, an investor also needs to have a decent accuracy. Accuracy of investment/trade is different from the risk to reward ratio, but both are required in order to gauge the overall performance of the portfolio. Accuracy defines how much trades/investment decisions generally goes right. An accuracy of 70% means 7 trades out of 10 hit the target price, and the remaining 3 yields loss.
For example, if a person has a risk to reward ratio of 1:1, meaning he is willing to lose $1 to make $1. He has an accuracy of 50%, meaning out of 10 trades his 5 trades go wrong and the other 5 go right.
After putting it all together, he would stand at break-even after 10 trades, as in 5 trades he would be losing $5 and would make $5 in the other 5 trades.
Now if the risk to reward ratio is increased to 1:2 he would make a decent profit even with the same accuracy of 50%; He would be losing $5 in 5 trades but would be making $10 in the remaining 5 trades, giving him a net profit of $5.