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Risk & Reward Ratio

In life sometimes it’s good to take risk, but we have to always be prepared for the consequences. This idea applies to the market as well, whenever we select a stock there are underlying risks, the only difference is the size of the risk. However, these risks can be compensated by rewards that can be reaped from the investment. Therefore to maintain a balance in your investments or trades, one has to make calculated risk to ensure that the investment is worth it.

Today we’ll show you a method to help you create a risk-reward balanced portfolio.

Investors naturally seek for lower risk investment in a volatile capital market. The risk-to-reward ratio (RRR) is a commonly used strategy by traders to measure their portfolio profitability. RRR compares the expected returns of an investment vs. the amount of risk in order to achieve these returns. The ratio defines the amount of risk that the investors are willing to lose in order to obtain the expected rewards of the investment. Traders divide the amount of risk (potential losses) if the price would move against them by the number of rewards (profit) that they are expecting.

Over the years, traders/investors are advised that high risk is equivalent to high return. However, placing an appropriate stop loss can protect the trader/investor’s capital. Without the stop loss mechanism, the unlimited risk poses a significant threat towards the trader’s portfolio. Simultaneously, expected returns should be higher than expected loss. While there is no fixed ratio, traders are advised to make trades based on an RRR of 1:2 or 1:3.

Let’s have a look at an example below.

risk n reward air asia-01.jpg
Strategy: Entry upon the short-term consolidation breakout of RM2.94
Target Price: RM3.16–RM3.30 (potential gain 7.5%–12.2%)
Stop Loss: RM2.77 (-5.8%)

Based on AIRASIA’s chart above, the trading’s risk-to-reward ratio can be calculated by (RM3.16-RM2.94) : (RM2.94-RM2.77). This leaves us RM0.22:RM0.17 or a risk-to-reward ratio of 1:1.3.

In the event AIRASIA could re-test the RM3.30 level, the risk risk-to-reward ratio would be (RM3.30-RM2.94) : (RM2.94-RM2.77). This leaves us RM0.36 :RM0.17 or a risk-to-reward ratio of 1:2.1.

So how will it pan out if you use this RRR method? Here’s an example

Suppose, Mr X, performed 10 trades with capital of RM10,000. With that, Mr X can either make or lose money (50% probability each in winning and losing).

table-01

Based on the above example with a risk-to-reward ratio of 1:2, out of 10 trades, 5 trades generated a return of 10% while the remainder 5 trade loses 5%. Hence, Mr. X’s net gain/loss will be; (RM5000 x 10%) – (RM5000 x 5%) = RM250 or 2.5% gain out of RM10,000 capital traded.

Looks too good to be true?

Well, a concept would just be an idea unless it is put to good use. It still relies on your accuracy to select the right stocks. This method might just be the way for you to be more cautious on your trades.

Does this interest you? If you wish to learn more why not get in touch with one of our dealers? Our licensed dealers will be able to guide and assist you along your trading journey.

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