Risk

Example of the Risk/Reward Ratio in Use

Consider this example: A trader purchases 100 shares of XYZ Company at $20 and places a stop-loss order at $15 to ensure that losses will not exceed $500. Also, assume that this trader believes that the price of XYZ will reach $30 in the next few months. In this case, the trader is willing to risk $5 per share to make an expected return of $10 per share after closing the position. Since the trader stands to make double the amount that she has risked, she would be said to have a 1:2 risk/reward ratio on that particular trade. Derivatives contracts such as put contracts, which give their owners the right to sell the underlying asset at a specified price, can be used to similar effect.

If a more conservative investor seeks a 1:5 risk/reward ratio for a specified investment (five units of expected return for each additional unit of risk), then he can use the stop-loss order to adjust the risk/reward ratio to his own specification. In this case, in the trading example noted above, if an investor has a 1:5 risk/reward ratio required for his investment, he would set the stop-loss order at $18 instead of $15—that is, he is more risk-averse.