While risk is a part of equity trading, it is important to know what amount of risk you are undertaking to capture a potential return on your investment. Here’s a tool that could help you gauge the risk-return potential of your equity investments.

The risk–return ratio is also referred to as the risk- reward ratio. It is calculated by dividing the potential / expected return on an investment with the maximum possible loss that could be incurred. For instance, the Nifty Futures for the August’08 series is currently trading at 4410 and suppose you buy a contract with a target level of 4500. You also place a stop loss at 4365 in order to insulate yourself against the possibility of a downward movement in the Nifty. Thus, your loss is restricted to Rs 45 while your potential return is Rs 90. The risk-return ratio would be 2 (Rs90 / Rs 45). Typically, the risk return ratio should at least be 2 and more. And naturally, a higher ratio is favourable. Investments yielding a risk return ratio of below 2 are best avoided.     

Risk-return ratio for derivatives

The risk return criteria can be applied on various derivative strategies. For instance, our derivatives research team recently issued a strangle call on Nifty options with a view that the market would be range bound in the near term. The strategy involved writing of a Nifty put option at strike price Rs 4,300 and writing a call option at strike price Rs 4,500. The total inflow of premium on the two contracts amounted to Rs 85. In this strategy, the downside potential is unlimited while the returns are restricted to Rs 85, which is the premium earned. If we assume that the Nifty settles out of the range at the time of the expiry of the contract at 4,200 then the counter party would execute the Put option and our risk-return ratio in such an eventuality would be Rs 85 / Rs 15 = 5.6 which is quite attractive. A similar analysis could be carried out if the Nifty settles at 4600 at the time of expiry. 

Exercise caution

If the spot Nifty moves sharply in either direction, say to 4000 or 4800 then the losses would increase drastically. Even if you try to square off the written options, you would incur a higher cost than what you earned on writing the options. This would yield an unfavourable risk-return ratio. So, what we understand from this example is that the calculation of the risk-return ratio was on the basis of a forecasted risk with the future return being fixed (Rs 85). In some cases, the risk is known but the return is forecasted, as we saw in the very first example of this write up relating to Nifty futures. There are also instances where the ratio is calculated on the basis of both the variables – return and risk- being assumed.