Assessing the amount of risk inherent in an investment is an important part of trading on the financial markets. Before executing a trade, it is only prudent to evaluate whether the risks are higher than the expected returns in relation to the amount of capital to be invested. Learn here how to assess the Risk/Reward ratio when you trade binary options.
How to Assess the Risk-Reward Ratio in Binary Options Trading
When it comes to trading commodities using binary options, you want to execute a risky trade only if the rewards will ultimately be significant enough to compensate the capital invested. An investment that that does not have a significant compensatory reward has a negative risk-reward ratio. Assessing the risk-reward ratio will allow you to reduce your exposure to potential risk while increasing your chances of making a profit.
Why should you think of the potential risks first before the profits? Fast moving price points combined with market volatility can set the trade against your odds. Ideally, you should have a ratio of 1:1 so that your potential risk is equal to your potential reward. To attain such a position requires that you perfect your trading technique.
One way of evaluating the risk-reward ratio of a certain asset is to first assess its value and strength in the marketplace. It’s also important to evaluate how well the asset is performing with regard to other assets on the market.
What is the Risk-Reward Ratio?
If somebody you marginally trust asks for a $100 loan and offers to pay you $120 in two weeks, it might not be worth the risk, but what if they offered to pay you $200?
That's a 2:1 risk/reward, which is a ratio where a lot professional investors start to get interested. A 2:1 ratio allows the investor to double their money. If that person offered you $3000, then the ratio goes to 3:1.
Example of how a simple risk-reward ratio is can be calculated:
The calculation of risk-reward ratio is simple. You simply need to divide your net profit (the reward) by the price of your maximum risk.
Say a certain commodity has a payout of 80% if the trading session ends in-the-money. If your broker does not offer an out of the money refund, the refund ratio is fundamentally 0%. As such, your upfront reward ratio is 4:5 such that if you invested $200 you can expect a maximum win of $160 and a loss of $200.
Another example using EUR/USD could be the following: let's set 50 pips stop loss. We have a $10000 account. and we only wnat to invest 3% of our capital (0.03 x $10000 = $300). It means 50 pips equals $300, that is our risk. But what is the reward? Reward is the profit that we can make in a trade. If we choose a 100 pips target for our trade and EUR/USD market hits this target, we will make $600 (as 50 pips equals $300, so 100 pips equals $600). This $600 profit is fthe reward. So the risk/reward ratio of this trade is 150:300 = 1:2.
Some traders won't commit their money to any investment that is not at least 4:1, but 2:1 is considered the minimum by most investors.
The Risk-Reward ratio is often used in combination with other risk management ratios, such as the "the break even percentage" (which gives the number of winning trades that are required to break even) or the "win to loss ratio" (which compares the number of winning and losing trades).
To comprehensively evaluate the market position and performance of a commodity, you need to use technical analysis to get a clear picture of an estimated risk-reward ratio.