The risk-reward ratio is one of the most powerful concepts in trading. It tells you how much you stand to gain compared to how much you are risking. Understanding and applying risk-reward ratios can transform a mediocre strategy into a profitable one.
What is Risk-Reward Ratio?
The risk-reward ratio (often written as R:R) compares the potential profit of a trade to its potential loss. It is calculated by dividing the distance to your profit target by the distance to your stop loss.
Risk-Reward Ratio = Potential Profit / Potential Loss
A 1:3 risk-reward ratio means you risk $1 to potentially make $3.
How to Calculate Risk-Reward Ratio
Let us work through an example:
- Entry price: $100
- Stop loss: $95 (risk of $5 per share)
- Profit target: $115 (reward of $15 per share)
Risk-Reward Ratio = $15 / $5 = 3:1
This means for every dollar you risk, you could potentially make three dollars. A 3:1 ratio is considered excellent.
Why Risk-Reward Matters
You Do Not Need to Be Right Often
With proper risk-reward ratios, you can be profitable even with a low win rate. Consider this example:
- 10 trades with 1:3 risk-reward
- Risk $100 per trade
- 40% win rate (4 wins, 6 losses)
Results:
- 6 losses x $100 = -$600
- 4 wins x $300 = +$1,200
- Net profit: +$600
Even winning only 4 out of 10 trades, you still made money because your winners were three times larger than your losers.
The Breakeven Win Rate
Every risk-reward ratio has a corresponding breakeven win rate:
Breakeven Win Rate = 1 / (1 + Risk-Reward Ratio)
| Risk-Reward | Breakeven Win Rate |
|---|---|
| 1:1 | 50% |
| 1:2 | 33% |
| 1:3 | 25% |
| 1:4 | 20% |
| 1:5 | 17% |
Finding Good Risk-Reward Setups
Look for Clear Support and Resistance
The best risk-reward setups occur near strong technical levels. Entering near support allows a tight stop loss while targeting resistance for larger gains.
Trade with the Trend
Trend-following trades typically offer better risk-reward because price is more likely to continue in the trending direction.
Wait for Pullbacks
Rather than chasing breakouts, wait for pullbacks to support levels. This improves your entry price and risk-reward ratio.
Risk-Reward in Practice
Minimum Acceptable Ratio
Most professional traders require at least a 1:2 risk-reward ratio before taking a trade. This means they skip many setups that do not offer sufficient potential reward.
Adjusting for Probability
A trade with 80% probability of success might justify a 1:1 ratio, while a lower probability setup needs a higher ratio to be worthwhile. Consider:
Expected Value = (Win Rate x Average Win) - (Loss Rate x Average Loss)
Example Expected Value Calculation
- Win rate: 50%
- Risk-reward: 1:2
- Risk per trade: $100
Expected Value = (0.50 x $200) - (0.50 x $100) = $100 - $50 = +$50 per trade
Common Mistakes with Risk-Reward
1. Unrealistic Profit Targets
Setting a 1:5 target is meaningless if price never reaches it. Targets should be based on realistic technical levels, not wishful thinking.
2. Moving Stop Losses
Widening your stop to avoid being stopped out destroys your planned risk-reward ratio. If the stop is hit, the trade thesis was wrong.
3. Exiting Winners Too Early
Taking profits at 1:1 when you planned for 1:3 reduces your actual realized risk-reward. Trust your analysis and let winners run to target.
4. Ignoring Win Rate
A 1:5 ratio is worthless if your strategy only wins 10% of the time. Risk-reward must be evaluated alongside win rate.
Analyze Your Risk-Reward Performance
Pro Trader Dashboard calculates your actual risk-reward ratios across all trades, showing whether your targets and stops are realistic.
Advanced Concepts
R-Multiples
Many traders measure performance in R-multiples, where R equals the amount risked. A trade that makes 3x your risk is a +3R trade. This standardizes performance across different position sizes.
Scaling Out
Some traders take partial profits at 1:1 or 1:2 and let the remainder run for larger targets. This locks in some profit while maintaining upside potential.
Trailing Stops
Rather than fixed targets, trailing stops let winners run indefinitely while protecting profits. This can improve effective risk-reward on strong trends.
Summary
Risk-reward ratio is fundamental to profitable trading. Always know your potential profit and loss before entering a trade. Aim for at least 1:2 ratios on most trades. Remember that risk-reward and win rate work together - high ratios let you profit even with modest win rates. Base targets on realistic technical levels, not arbitrary numbers. Track your actual realized risk-reward to ensure your execution matches your plans.
Learn more: how to set stop loss levels and when to take profits.