One of the most used metrics in crypto trading is the risk/reward ratio. It compares the possible loss with the profit expected from a particular trade. For example, a trade with a risk/reward ratio of, let’s say, 1:4 means that the trader gains four dollars for every dollar risked.
How to Calculate the Risk/Reward Ratio
Suppose the market price of Bitcoin is $45,000; a trader might open a long position using the parameters below:
Entry price: $45,000
This is the price at which the trader purchases BTC.
Stop-loss: $44,000
Stop-loss is a risk management measure that prevents further losses. In this case, if the BTC price trends down, the trade will automatically close at $44,000. In other words, the trader is risking $1,000 per Bitcoin purchased for $45,000.
Take profit: $49,000
If BTC rallies as per the trader’s expectations, their position will be closed at the take profit point, making a profit of $5,000, which becomes their reward.
To calculate the risk/reward ratio, divide the initial risk ($1,000) by the reward ($5,000). The outcome will be 1:5.
What are the Advantages and Disadvantages of the Risk/Reward Ratio?
One of the pros of the risk/reward ratio is that it helps a trader to evaluate potential rewards and losses associated with a certain trade and then make accurate decisions. It also makes it possible for one to adopt effective risk controls like take-profit and stop-loss points.
But the risk/reward ratio also has its downside. So it is important to highlight that it doesn’t guarantee success. The major weakness of this metric is that it’s based on assumptions regarding the future price movement of a crypto asset, which may sometimes take an unexpected direction.
That said, traders should never solely rely on the risk/reward ratio. Instead, they should use it along with other risk controls.
How to Optimize the Risk/Reward Ratio
Many traders consider 1:2 as the optimal risk/reward ratio, but that does not mean you shouldn’t adjust it to suit your trading strategy. Here are some elements to consider before optimizing the risk/reward ratio:
Position size:
Position size represents the amount of crypto allocated to a trade. It has a significant impact on the risk/reward ratio; that is, a bigger position size increases both potential profits and losses. On the other hand, the smaller the position size, the lower the possible profit or loss.
Win rate:
This metric calculates how often one closes profitable trades. A trader with a high win rate does not need to adjust the risk/reward ratio above 1:2 because they profit more often. Conversely, if a trader has a low win rate, it means they usually target to make big profits from a single trade, thus the need to optimize the risk/reward ratio.
Maximum drawdown:
Maximum drawdown measure how much money a trader has lost since they started trading. But how does this metric impact the risk/reward ratio?
Suppose the risk/reward ratio of a trader is 1:3, meaning they’re risking $1 to make $3, and the maximum drawdown of their trading strategy is 55%. In that case, it’s likely that the trader could lose more than half of their funds before their strategy starts generating profits.
Factors to Consider When Determining the Risk/Reward Ratio in Crypto Trading
Below are some factors influencing crypto trading that traders must take into account when determining the risk/reward ratio.
Crypto market volatility
One thing that separates the crypto market from traditional financial markets is its volatility. Trades can go against you anytime, so consider this when setting the risk/reward ratio.
Liquidity
Liquidity represents the number of crypto assets available on an exchange to enable quick swapping of tokens. Low liquidity causes slow execution of trades and thus may affect traders’ ability to realize profits.
Strength of the Traded Token
Before trading a token, ensure it has use cases. That’s because a token that solves problems increases its chances of being around for a while and reduces the risk associated with trading it.
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