How to determine Risk Reward Ratio
Was hoping someone could explain to me how do you determine Risk Reward ratio when analyzing a stock
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Depends on how you quantify risk. The "academic way", which accepts that risk can be approximated with volatility (many of us question the merit of this assumption but that's another discussion) is a Sharpe Ratio, i.e. to divide excess return by the standard deviation of returns. There are some permutations on this but it is probably the most common answer you'll hear and the easiest way to arrive at a single number.
That said, most of the time, when you hear investors talk about "risk adjusted return" or "attractive risk-reward ratio", they're speaking far more qualitatively, by considering the return potential in light of plausible risks (including but not limited to volatility). The farther you move from deep, liquid markets for a particular asset, the less meaningful calculating a Sharpe ratio becomes. (As an extreme example, consider a private equity deal for a company that has never been public; it's impossible to quantify variability of valuation in any meaningful sense.)
Thank you for the response that was very helpful. So in terms of volatility and risk adjusted returns, does that mean that investors would avoid volatiltiy even if it was all expected to be positive (take $FSLY about 2 months ago for example). The return was still very strong, but since there was a lot of volatility throughout the time frame (even if it is all positive) then your risk adjusted return was poor?
Why is this guy being MS-Ed right? He’s spot on
how much money can you make to how much money you can lose
comparison metric to use among stocks, similar to ebitda multiples
Stock A: currently $10, risk price of $7 and target price of $15. 50% upside, 30% downside = 1.67x R/R
Stock B: currently $10, risk price of $8 and target price of $20. 100% up 20% down = 5.0x R/R
All else equal you would rather invest in stock B.
How would you determine the risk price? I appreciate the reply
you forgot to probability weight them. If the target price of $20 in a high scenario is 25%, base case is 30% probability it stays flat i.e. $10 and downside is 45% for $8, that's a worse scenario at $11.6 EV vs. scenario A if those were weighted $15 at 70% and $7 at 30% = $12.6.
Before anyone asks...most of the time (ex quant strats) there is no science to fundamental R/R probabilities, it is just your best estimate on what the decision tree outcomes may look like. In equities without a catalyst, it is very much finger in the air.
Didn't forget, I personally don't find a lot of value in doing that. I think it gives you a false sense of precision, and honestly R/R is probably best used as a reference tool than the be all end all. Like you said, investment is more art than science.
That said it's probably more important at an event shop.
Same way you determine target price but with the things that could go wrong
so basically a base case vs bull case. At first I thought when u said price target you were talking about analyst recommendations which is why I was confused about a risk price
Yup
Here is another way to look at it. I do this for a portfolio that is growth oriented but is also paying very close attention to income. It helps screen for ideas and also with weights relative to the benchmark.
I look at volatility of the equity price over a period of time. This matters when you have to mark to market and it flows directly to a corporate income statement. Then I look at current income plus growth in income. Divide the expected total income by volatility. This provides a very simplistic expected return for income given a level of equity volatility. Makes it easier to compare individual holdings or a portfolio across asset classes and can show some surprising results. I also do the same for expected share price return.
One tool in the toolbox.
Well the simplest way to determine risk-reward ratio would be to look at your target price, compared to your stop-loss price. So what price are you targeting? When will you sell your stock? Also, what is your stop loss where you will sell to limit your losses? Then basically do a ratio between those two values (in terms of potential percentage gain vs. potential percentage loss). That can be your risk /reward ratio (or reward /risk ratio depending on how you divide the numbers). Usually you can determine what your target and stop loss are by doing some technical analysis on the stock chart, and looking for points of support and resistance to determine your target and stop points.
Fuck your stupid blue link
Bruh why do you always comment this same exact thing
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