Calculate Risk/Reward by dividing profit (reward) by your maximum risk. You may notice the equation of often written incorrectly as I did here. Investors often speak of Risk/Reward to Risk to Reward, but they actually mean the opposite: Reward to Risk or Reward/Risk. It’s the same as Profit/Loss or P&L. What we really mean is how much Reward is achieved for the Risk taken, so it’s Reward/Risk.
Reward to Risk Ratio
If we risk $1 to earn $2, that’s a Reward/Risk or Reward to Risk ratio of 2:1. The Reward was twice as much as the risk. This could be used in different ways to illustrate Reward to Risk.
- Before an investment position is entered we can Calculate the Reward to Risk potential.
- If we enter a position at $50 per share and expect it could trend to $60, that’s a $10 increase or 20%. That may not seem like a lot and it isn’t if you are risking all of the investment. But, if you limit the loss to $5 and predetermine that we’ll exit at $45, then the Reward to Risk is much more of an edge.
- After an investment position is closed (sold) we can Calculate the Risk to Reward achieved.If we entered a position at $50 per share and it trended to $60 and we sold it, that’s a $10 increase or 20% realized profit. A gain is not realized as a profit until it is sold. Simply being “up” in a position doesn’t mean you really have a profit.
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