What Is the Risk/Reward Ratio, and How Can You Use It 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 to maximise profits and minimise losses. One of the tools for risk management in cryptocurrency trading is the risk/reward (RR) ratio. In this FXOpen article, you will learn the RR ratio crypto meaning, how to calculate it, how to balance losses and profits when trading cryptocurrencies, and how to place stop-loss and take-profit orders based on it.

What Is the Risk/Reward Ratio?

The risk/reward (RR) ratio is a risk management tool used by traders to measure the possible profit against the potential loss of a position and to adjust entry and exit points for successful trading. In other words, it is a metric that shows how much a trader may make in a trade compared to the amount of money they may lose. Traders commonly look for the best high-risk, high-reward cryptos. However, even if you are looking for risky assets, it’s worth using protective tools, such as the RR ratio, to limit losses in unfavourable market conditions.

The RR ratio calculation is relatively straightforward. By using fundamental and technical analysis, you determine a profit target, which is the price at which they plan to close the position with returns. Also, you analyse the market and calculate the possible loss based on the price at which you will exit the market if the price moves in the opposite direction to their forecast. To calculate the RR ratio, you need to divide the expected loss by the expected profit. Let’s 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 profit). This means that the trader stands to make 0.5 times their initial investment if the position is successful. 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 profits 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 expected losses.

In general, 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 they 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 profits. However, it’s 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 to 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. Let’s consider a cryptocurrency risk/reward ratio on a live chart.

Imagine we went short on BTCUSD at $27,794. The take-profit target lay 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, 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

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 features of cryptocurrencies that discourage traders with little experience from entering the market. However, there are tools that can help you 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.

Takeaway

The RR ratio is a critical tool for managing risk and maximising 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 live markets.

FAQ

What should be the risk/reward (RR) ratio for crypto trading?

The RR ratio for crypto trading should be calculated based on the trader’s strategy, budget, and level of experience. The theory suggests that the 1:2 and 1:3 ratio is the most optimal for trading.

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.

What is the RR (risk/reward) ratio?

The risk/reward (RR) ratio is a risk management tool used by traders to determine the effectiveness of a position by comparing expected losses and returns. The greater the ratio, the safer the position is. Conversely, a lower one reflects greater risks.

What is risk to reward in cryptocurrency?

A risk-to-reward ratio in a cryptocurrency refers to a metric that reflects possible losses compared to possible profit per trade in the market. Due to the highly volatile nature of cryptocurrencies, the theory recommends that traders use large ratios.

*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.

This article represents the opinion of the Companies operating under the FXOpen brand only. It is not to be construed as an offer, solicitation, or recommendation with respect to products and services provided by the Companies operating under the FXOpen brand, nor is it to be considered financial advice.

Text source: Forex Trading Blog

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