Risk reward ratio is an often used term by investors and traders alike. I use risk reward ratio to find out potential trades and to avoid certain others.
What is Risk Reward ratio?
Risk reward ratio is a mathematical equation which is calculated by dividing,the amount the trader stands to lose if the price moves in the unexpected direction (the risk) by the amount of profit the trader expects to have made when the position is closed (the reward)(Source:Investopedia)
How much should be the ideal risk reward ratio?
If you buy a stock for Rs.45 with target of 50 and stoploss at 40, the risk reward ratio is 5/5=1 .So you may have 50% chance to lose Rs.5 or gain Rs.5. Every trade cannot be a success if 50% of the trades you make become profitable even then you will be running at a loss( Brokerage and other charges). So you have to avoid setups with RR=1.
The higher the RR, the better. Consider a stock with price of 45 with target 55 and SL at 40.Here the RR is 5/10=1:2. So in this case is 50% of your trades become profitable, you will be having surplus money. So as the RR increases your profitability increases.
A trader selecting stocks with RR 1:3 will be theoretically in profit, if he executes his trades as per plan ie holding till target price is reached and exiting at stoploss price.So select stocks with low and avoid trading setups with high and become a profitable trader.