Risk reward structure in trading

15 days ago

Risk reward structure in trading

Trading comes always with risks. This represents basically the chance that a trader takes to get the opportunity to make a profit. A large part of trading of any type of assets resolves around keeping risks as low as possible and at the same time still having an awesome opportunity to make profit.

In order to achieve this goal, one must find a balanced ratio between risk and reward each time before making a trade.

What is considered as a risk?

Generally speaking, everything is considered as a risk if it threatens to lose money. Since there is no profit to be made without taking at least a minor risk, traders usually learn to live with the imminent threat to lose their money.

Aside from these general concerns there are more specific aspects to consider. Each trade comes with specific circumstances that will define the risks involved. In order to assess the risks, one need to consider a lot of aspects.

This includes but is not limited to position size, market sentiment, volume and even more important, the possible downside of each trade.

Defining the ratio

The basic idea is that a trader expects a certain return for each Dollar or Euro he risks losing. Meaning that aside of identifying risks he also needs to assess the opportunity that a trade has to offer.

If a trade promises 100 Euro in return for each Euro that is at risk, the ratio is 1:100. While these round numbers make a perfect example, they don’t occur very often during trading. In fact, many traders are happy with a much lower ratio.

A ratio of 1:3 is very common, but a trader might also choose to aim for much higher goals since cryptocurrencies are considered much more volatile unlike stocks or any other security for that matter. There is no such thing as a perfect ratio, but only the ratio that a trader deems to be acceptable.

Avoiding high risk

It is crucial to understand that risk cannot be avoided by definition. Still, very high risks that offer little or no returns should be considered as a red flag. While opportunities involving little or less risk possibly offer a good position.

Please note that this method strongly relies on one’s ability to assess both risk and opportunity correctly. Meaning that a false assessment of the situation will basically produce a wrong ratio.

Therefore, the risk-reward structure in trading offers a method to reflect and manage your own expectation before making a trader, but only up to your own ability to assess the market.

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