Risk-Reward Ratio

What Is Risk-Reward Ratio?

The risk-reward ratio (R:R) compares the potential downside of a trade to its potential upside. It is calculated by dividing the risk (entry price minus stop-loss price) by the reward (target price minus entry price). A ratio of 1:2 means the potential profit is twice the potential loss. This metric is fundamental to trade evaluation and is used by virtually every disciplined trader.

The ratio forces a critical question before every trade: "Is the potential profit worth the risk I am taking?" By establishing this framework, traders systematically avoid trades where the potential reward does not justify the risk.

How Risk-Reward Drives Profitability

A strategy's profitability depends on the combination of win rate and risk-reward ratio, known as expectancy. The formula is: Expectancy = (Win Rate × Average Win) - (Loss Rate × Average Loss). A positive expectancy means the strategy is profitable over many trades.

With a 1:2 risk-reward ratio, a trader needs to win just 34% of trades to break even (before costs). With a 1:3 ratio, only 25% wins are needed. This math explains why trend followers can be profitable despite winning less than half their trades: their winners are significantly larger than their losers.

R-multiples express trade outcomes as multiples of risk. A 2R winner is a trade that made twice the initial risk. A 0.5R winner is one that was closed early, capturing half the planned profit. Tracking R-multiples across all trades provides a clear picture of the strategy's expectancy and consistency.

Applying Risk-Reward in Practice

Before entering any trade, define three prices: entry, stop loss, and profit target. Calculate the ratio. If it is below your minimum threshold (commonly 1:2), skip the trade regardless of how good the setup looks.

Position sizing is integrated with risk-reward by fixing the dollar risk per trade. If you risk $100 per trade (1% of a $10,000 account), a 1:3 R:R trade risks $100 to potentially gain $300. This consistent framework applies across all trades and ensures each trade contributes proportionally to the overall portfolio performance.