Risk/Reward Ratio Rules in Crypto Trading
Cryptocurrencies are a popular but highly volatile market, which comes with inherent risks. Therefore, you should know how to manage these risks appropriately. The risk/reward (RR) ratio is one of the tools for risk management in crypto markets. In this FXOpen article, you will learn the RR ratio crypto meaning, how to calculate the ratio, and how it can help you balance potential losses and returns when trading cryptocurrencies.
What Is the Risk/Reward Ratio in Trading?
Traders commonly look for the best high-risk, high-reward cryptos. However, even if you are looking for risky assets, its worth using protective tools, such as the risk-reward ratio, to potentially limit losses in unfavourable market conditions.
The risk/reward (RR) ratio, or risk-return ratio, is a risk management tool used by traders to measure possible returns against potential losses in a trade and to adjust entry and exit points for effective trading. It is a metric that shows how much a trader can potentially make in a trade compared to the amount of money they may lose.
What Is the Risk/Reward Formula?
The RR ratio calculation is relatively straightforward. By using fundamental and technical analysis, a trader determines a profit target, which is the price at which they plan to close the position with returns. Also, they analyse the market and calculate the possible loss based on the price at which they will exit the market if the market moves in the opposite direction to their expectation. To calculate the RR ratio, they divide the expected loss by the expected return. Lets consider an example.
A trader decides to go long at $1,000. They believe that the cryptocurrency will increase in value, and they set a profit target of $1,500. However, the cryptocurrency market is highly volatile, so the trader sets a stop loss at $900 to limit their losses.
In this scenario, the RR ratio would be 1:5 ($100 loss / $500 return). This means that the trader stands to make 0.5 times their initial investment if the market moves in their favour. However, the possible loss is also significant, with the trader standing to lose $100 for every $1,000 invested.
By measuring the amount you may earn compared to the amount you can lose, you can assess whether the position makes sense and if the possible returns are worth the possible losses. If the amount you may earn is almost the same as what you may lose, it may not be a good time to enter the market.
What Is a Good Risk/Reward Ratio for Cryptos?
There is no single good risk/reward ratio, as it varies depending on the trader's risk tolerance and trading strategy. Some traders may be comfortable when the amount of expected returns is the same or almost the same as the amount they may lose if they are willing to take on more risk for potentially higher returns. Others may prefer positions when the expected returns are much higher than the expected losses.
The theory says that the RR ratio of at least 1:2 is the smallest traders should use. This means that expected returns should be at least twice the loss. Some traders may prefer a higher ratio of 1:3 or 1:4, while others may be comfortable with a lower one of 1:1.5 or 1:1. If you balance rewards and losses 1:1, you are ready to lose the same amount as you can earn. Such a small ratio is usually applied to scalping strategies, in which traders place short-term positions and aim for small but frequent returns. However, its vital to remember that the cryptocurrency market is highly volatile, and a small RR ratio may lead to an early exit.
The RR ratio can be used in conjunction with technical indicators, such as moving averages, support and resistance levels, and trendlines, to identify entry and exit points. For example, if a moving average reflects an upward trend, you may enter a long position with a profit target being much larger than a potential loss. Similarly, if you identify a resistance level indicating a possible price bounce, you may enter a short position with a larger take-profit target.
How Can You Set a Proper Profit Target?
Usually, when applying the RR ratio, traders start with a take-profit target. There are numerous ways to identify it. We will use the most common support and resistance levels. You can test different cryptocurrency risk/reward ratios on live charts on the TickTrader trading platform by FXOpen.
Imagine we went short on BTCUSD at $27,794. The take-profit target was at $27,216 (important swing lows). The expected returns would be $578. So, if we used a 1:2 RR ratio, we would have divided $578 by 2, which would be $289, and then we would have added the entry point to half of the returns ($27,794 + $289). The stop-loss level would have been at $28,083.
This approach works not only for support levels based on the closest swing lows; you can apply it to any method of support and resistance placement. Read our article How to place support and resistance levels.
Setting a Stop Loss Level
Another option is to identify possible losses and then place a take-profit target. Traders first determine the point at which their position will be invalid and then multiply the distance between it and the entry point by the ratio to calculate the possible returns.
High volatility is one of the unique features of cryptocurrencies that discourage traders with little experience from entering the market. However, there are tools that can help you potentially mitigate the risks of unexpected price movements. For instance, the average true range (ATR) indicator can help you place a stop-loss level that takes market volatility into account to avoid an early exit.
Imagine we went short on BTCUSD at $27,794 when the ATR was 172.85. Then we could have added 172.85 and 27,794; this would have been a stop-loss level ($27,966.85). If we used the 1:2 RR ratio, we would have doubled 172.85 and subtracted the result from the entry point. The target would have been $27,448.30. In the case of a 1:3 ratio, the target would have been $27,275.45.
You can examine how to use the ATR indicator and other tools on the TickTrader platform.
Common Mistakes to Avoid in Using the Risk vs Reward Ratio
Here are the most common mistakes traders face when implementing the risk/reward ratio in their strategies.
1. Chasing Unrealistic Ratios
One of the most common mistakes traders make is setting overly ambitious risk/reward ratios that are difficult to achieve. While aiming for a high reward with minimal risk sounds ideal, it can lead to unrealistic expectations. For instance, expecting a 1:10 ratio in a trade may lead to disappointment, as such opportunities are rare in the volatile crypto market. Traders may end up holding onto losing positions for too long, hoping for a massive turnaround that never comes.
2. Ignoring Market Analysis
Relying solely on the risk/reward ratio without considering broader market factors is another significant pitfall. The ratio is a tool, not a guarantee of effective trading. Market conditions, including trends, volatility, and news events, play a crucial role in determining whether a trade is likely to be effective. Ignoring these factors can lead to poor decision-making. For example, a trade with an excellent risk/reward ratio might still fail if its placed in a market with strong opposing trends. Therefore, traders should always combine the risk/reward ratio with solid market analysis to increase their chances of effective trades.
3. Overtrading
Improper use of the risk/reward ratio can lead to overtrading, which is the excessive buying and selling of assets. This often occurs when traders become too focused on finding trades that meet their desired ratio without considering the quality of the trade itself. Overtrading increases transaction costs, exposes the trader to more risk, and can lead to burnout. Moreover, not every market condition is conducive to trading, and forcing trades to meet a specific ratio can result in unnecessary losses. To prevent overtrading, its important to be patient and selective, ensuring that each trade is based on solid analysis and not just on meeting a predefined ratio.
Takeaway
The RR ratio is a critical tool for managing risks and maximising potential returns in cryptocurrency trading. Traders who do not use it may be more likely to make emotional or impulsive decisions. So, by using the RR ratio, you can set appropriate stop-loss levels and profit targets, manage your emotions, and make more informed trading decisions. Once you determine your perfect RR balance, you can open an FXOpen account to test it on over 600 live markets and enjoy tight spreads from 0.0 pips and low commissions from $1.50 per lot.
FAQ
What Is Risk to Reward in Cryptocurrencies?
The risk-to-reward ratio in cryptocurrencies is a metric used to evaluate the potential returns of a trade relative to the potential loss. In the highly volatile crypto market, this ratio helps traders decide whether a trade is worth pursuing. The "risk" refers to the potential loss if the market moves against your position, typically determined by setting a stop-loss order. The "reward" represents the potential gain if the trade goes in your favour, determined by your take-profit target.
What Should Be the Risk/Reward (RR) Ratio for Crypto Trading?
The RR ratio for crypto trading should be calculated based on the traders strategy, budget, and level of experience. The theory suggests that the 1:2 and 1:3 ratios are the most optimal for trading in any market, including cryptocurrencies.
How Do You Use the Risk-to-Reward Ratio in Trading?
The risk/reward (RR) ratio allows traders to evaluate losses and returns per position. For instance, if it equals 1:2, the potential reward is twice as high as the potential loss. The smaller the ratio, the riskier the trade is.
How Do You Calculate the Risk/Reward Ratio?
To calculate the risk/reward ratio, start by determining your entry price, which is the price at which you plan to initiate the trade. Next, establish your stop-loss or take-profit level. Then, set your take-profit or stop-loss level. The risk is the difference between the entry price and the stop-loss level, while the reward is the difference between the entry price and the take-profit level. The risk/reward ratio is then calculated by dividing the potential risk by the potential reward. A lower ratio indicates a more favourable trade.
What Rule Is Important to Remember When Evaluating Risks and Returns?
When evaluating potential risks and returns, it's crucial to remember that higher potential returns typically come with higher risk. However, the key rule is to ensure that the potential reward justifies the risk you're taking. This means consistently aiming for a risk/reward ratio that aligns with your trading strategy, often aiming for a minimum ratio of 1:2 or higher, depending on market conditions. Balancing the potential for returns with the possibility of loss is essential for sustainable trading.
*At FXOpen UK and FXOpen AU, Cryptocurrency CFDs are only available for trading by those clients categorised as Professional clients under FCA Rules and Professional clients under ASIC Rules, respectively. They are not available for trading by Retail clients.
Read more: https://fxopen.com/blog/en/what-is-the-risk-reward-ratio-and-how-can-you-use-it-in-crypto-trading/
Text source: Forex Trading Blog
