Investors compare the expected returns from an investment to the amount of risk involved to generate these returns in the form of risk-reward ratio.
Risk reward ratio is usually calculated by dividing the amount of loss an investor will have to bear incase the price of an asset has moved in an opposite direction than expected by the amount (risk) of profits the same investor expects to make when he closes his position (reward). In simple words, risk reward ratio measures the potential gains for every unit of risk borne by an investor.
It is usually used when trading in a specific stock and many investors consider a pre-determined risk reward ratio. The most ideal risk reward ratio is 1:3, which means that for every one unit of incremental risk, the reward is three times. Traders use various types of measures to manage their risks i.e. Stop Loss orders and derivatives in the form of put and call options.
Take for example: A trader purchases 1,000 shares of DCB Bank at Rs. 155 and places a stop loss at Rs. 150 to ensure that the loss does not exceed Rs. 5,000. Also, this trader believes that the price will reach Rs. 170 in the next few days. This indicates that the trader is willing to take a risk of Rs.5 for each share to earn a profit of Rs.15 per share. We can also say that the trader has a risk reward ratio of 1:3 (5/15). In a similar way derivative contracts like put options can be used to manage a risk reward ratio.
On a more macro level too risk reward ratio holds significance. If an investment carries high risk, the reward should be high to justify the same. Corollary to this, an investment offering high reward always carried higher risk – e.g. bank FD has less risk vis-à-vis equity, hence it has lower reward vs the equities, over a long time period. Historical average of Indian equity returns for the past 20 years has been about 13-14% whereas bank FDs have given interest of 6-8% p.a. indicating their lower risk nature.