Trading Toolkits

Trading Toolkits: Risk-Reward Explained

The sole intention for trading for many traders is to make a profit. No matter the type of trade activities or the market involved, all trade activities come with an element of risk. Learning how to manage this risk or a potential loss associated with trading is also known as the Risk-Reward Ratio (R:R).

What is Risk Reward Ratio?

The Risk-Reward Ratio marks the prospective reward a trader makes for every Dollar he risks. The trader takes on a trading position with the sole intention of making profits; however, due to circumstances that may be unforeseen or beyond the control of the trader results in a downtrend or a market reversal. He takes in this potential for loss in his trade by setting a stop-loss which takes him away from the market, saving him from more losses.

The RR is that region where he gets rewarded for his trade actions and simultaneously the area of invalidation that shows how much he had risked. This principle is well applied by Technical Analysts and can be used by their Fundamental Analyst counterparts.

How Does the Risk-Reward Ratio Work?

Conventionally traders set their reward at the next resistance and their risk below the support. Here is how it works:

For example, this chart of Cake/Usdt on the 4HR timeframe indicates the support and resistance zone.

Chart of CakeUsdt on the 4hr TF

Say a trader going long(buying) decides to take this trade. His area of resistance will be the yellow rectangle, and his area of support is the blue rectangle. The price at the time of this study is $17.938 (the red rectangle).

The support region indicates the Risk zone; Here, it shows a 4.70% potential loss if price decline to the area;

His resistance zone is his Reward zone; indicated to be 7.69% above the current price;

Calculating his Risk Reward Ratio = Risk/Reward = 4.70%/7.69% = 1:2. I.e for every $1 risked, a potential $2 is his reward.

Why is Risk-Reward significant?

Applying RR to your trades ensures you don’t trade blindly, filled with high hopes and unnecessary hype. It gives you a determined and disciplined path to follow with expectations and targets. To a large extent, Risk-Reward keeps you sane in an overtly hype-driven market and holds your hand steady. Experienced traders use the RR to ensure profitability and liquidity at all times. 

What are the Weaknesses of Risk-Reward?

Applying Risk-Reward principles by itself does not constitute any weaknesses. Not using any increases your chances of blowing up your account. This holds especially true in a bear market where the potential for loss is higher than in a bull market. This method’s inapplication could see you waking up to a zero balance account.

Even in a bull market not setting a stop loss that marks off your risk region could see a potential heavy loss when a correction or a bear trend suddenly set in.

In Conclusion

A profitable trader who wishes to stay solvent in the market must manage s risk. They must know how to check h potential loss or profit with the Risk-Reward Ratio strategy.

In a highly volatile market like that of the cryptocurrency section, it’s easy to make money and lose heavily. Not having a realistic target could lead to a large loss of funds and disappointment, eventually leading to a close of your trading activities.

Mitigate losses by applying this principle and stay on the market for as long as you intend to go. Kindly apply caution to your trade with this strategy as it’s one of many ways to risk management in trading.

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