When you enter a stock trade, measuring its success simply by the profit or loss does not tell the whole story. Two trades may both make $500, but if one risked $1,000 to achieve that gain while the other only risked $250, their true effectiveness is quite different. This is where risk-adjusted returns come in: they allow you to evaluate trades by considering potential reward in relation to the risk taken. This guide will help you understand what risk-adjusted returns are, how to calculate them, and how to use them to improve your trading decisions and portfolio management.
What Are Risk-Adjusted Returns?
Risk-adjusted returns are performance measures that reflect the return of an investment relative to the amount of risk involved. Instead of looking at absolute gains or losses, these metrics help you evaluate how efficiently you are using your capital and risk to generate returns.
Common measures include:
- Risk-Reward Ratio: The ratio comparing the potential loss (risk) of a trade to its potential gain (reward).
- Sharpe Ratio: Measures return relative to volatility (standard deviation of returns), often used for portfolio performance.
- Sortino Ratio: Similar to Sharpe but only penalizes downside volatility, focusing on harmful risks.
For most individual stock trades, the Risk-Reward Ratio is the simplest and most actionable starting point. It helps you set up trades where the potential profit justifies the potential loss.
Calculating Risk-Reward Ratio: Step-by-Step
The Risk-Reward Ratio is calculated as:
Risk-Reward Ratio = (Potential Loss) / (Potential Gain)Where:
- Potential Loss = difference between your entry price and your stop-loss price, multiplied by position size
- Potential Gain = difference between your target price and your entry price, multiplied by position size
A ratio below 1 means your potential gain is greater than your potential loss, which is generally preferred.
Worked Example: Calculating Risk-Reward Ratio
Suppose you plan to buy 100 shares of Stock XYZ:
- Entry price: $50
- Stop-loss price: $47 (you will exit if price falls below this)
- Target price (take-profit): $60
Calculate the potential loss and gain:
- Potential Loss per share = $50 - $47 = $3
- Potential Gain per share = $60 - $50 = $10
- Total Potential Loss = $3 x 100 = $300
- Total Potential Gain = $10 x 100 = $1,000
Risk-Reward Ratio = 300 / 1000 = 0.3
This means for every dollar risked, you expect to gain about $3.33, which is favorable.
Using Risk-Adjusted Returns in Trade Selection and Management
To improve your trading results, consider these principles:
- Set minimum acceptable risk-reward ratios. Many traders aim for ratios of at least 1:2 or 1:3 to provide a buffer against losing trades.
- Reject trades with poor risk-reward profiles. Even if the setup looks promising, a trade with a small potential gain relative to risk may not justify taking the position.
- Adjust position sizing based on risk. Allocate less capital to trades with tighter stop losses or more risk to keep your overall risk controlled.
- Evaluate past trades using risk-adjusted metrics. Review your trading journal to assess whether you are achieving adequate returns for the risks you are taking.
Checklist: Evaluating a Trade Using Risk-Reward Ratio
- 1. Identify entry price.
- 2. Determine stop-loss price based on your risk tolerance and technical levels.
- 3. Establish take-profit target based on realistic price movement or technical resistance.
- 4. Calculate potential loss and gain per share or contract.
- 5. Calculate risk-reward ratio = potential loss / potential gain.
- 6. Is the ratio below your minimum threshold (e.g., 0.5)? If no, reconsider the trade.
- 7. Adjust position size so that the total risk does not exceed your allowed trade risk budget.
Going Beyond Risk-Reward: The Sharpe and Sortino Ratios
For portfolio-level assessment or strategy evaluation, risk-adjusted measures that include return variability can be useful:
- Sharpe Ratio = (Average Return - Risk-Free Rate) / Standard Deviation of Returns. It indicates how much return you receive per unit of total risk (volatility).
- Sortino Ratio adjusts the Sharpe by considering only downside fluctuations, which are usually more relevant to traders concerned about losses.
While these ratios typically require a series of trade returns or portfolio returns over time to calculate, they provide valuable insights on the quality of your overall performance.
Common Mistakes When Using Risk-Adjusted Returns
- Ignoring trade probability. A great risk-reward ratio doesn’t guarantee success if the chance of hitting the target is very low.
- Setting unrealistic profit targets. Overly ambitious targets can inflate the perceived reward and skew your ratios.
- Neglecting to update stop-loss and target levels as the trade progresses. Dynamically managing your exit points can improve performance but requires discipline.
- Forgetting position sizing. Failing to size positions according to risk invalidates the usefulness of the ratio in managing portfolio risk.
- Overemphasizing single trades. Focus on patterns of trades and portfolio-level risk-adjusted results rather than isolated trades to get a clear picture of your performance.
Practice Plan (7 Days): Applying Risk-Adjusted Return Concepts
- Day 1: Study your recent 5 trades, note entry, stop, target prices, and calculate their risk-reward ratios.
- Day 2: Look for 3 current trade setups and calculate risk-reward ratios for each.
- Day 3: Review your trading journal entries from the past month to identify patterns of risk versus reward.
- Day 4: Select 2 hypothetical trades, adjust stop-loss or target to improve their risk-reward ratios without sacrificing realism.
- Day 5: Practice creating trade plans including position sizing based on maximum tolerable risk and risk-reward ratios.
- Day 6: Read about Sharpe and Sortino ratios and reflect on how you could track your performance over time.
- Day 7: Set guidelines for minimum acceptable risk-reward ratio and position size limits; apply these rules in your simulated or paper trades this week.
Key Points
- Risk-adjusted returns give a fuller picture by balancing potential gains with risks taken.
- Risk-reward ratio is a simple and effective tool to evaluate individual trade opportunities.
- Apply minimum risk-reward thresholds and appropriate position sizing to improve discipline and risk management.
Risks and Pitfalls to Avoid
- Overestimating reward and underestimating risk can lead to poor trade outcomes.
- Ignoring the probability of success may cause holding onto setups with unfavorable odds despite good risk-reward ratios.
- Neglecting position sizing risks excessive losses and portfolio damage even when risk-reward looks attractive.