Risk-reward ratio is one of the most fundamental concepts in trading. It determines whether your trading strategy can be profitable over time. In this comprehensive guide, we will cover everything you need to know about risk-reward ratios: how to calculate them, what ratios to target, and how they interact with win rate to determine profitability.
What is Risk-Reward Ratio?
Risk-reward ratio compares how much you stand to lose on a trade (risk) versus how much you stand to gain (reward). It is typically expressed as a ratio like 1:2 or 1:3.
Simple definition: If you risk $100 to potentially make $200, your risk-reward ratio is 1:2. You risk 1 unit to gain 2 units.
How to Calculate Risk-Reward Ratio
Basic Calculation
Risk-Reward Ratio = Potential Reward / Potential Risk
Example trade:
- Entry price: $50
- Stop loss: $48 (risk = $2 per share)
- Target price: $56 (reward = $6 per share)
- Risk-Reward = $6 / $2 = 3:1
For every $1 risked, you can potentially gain $3.
Risk-Reward and Win Rate: The Relationship
Risk-reward ratio and win rate work together to determine profitability. You can be profitable with low win rates if your risk-reward is high, or with high win rates if your risk-reward is low.
Break-Even Win Rates
For different risk-reward ratios, here are the minimum win rates needed to break even:
- 1:1 ratio: Need above 50% win rate
- 1:2 ratio: Need above 33% win rate
- 1:3 ratio: Need above 25% win rate
- 1:4 ratio: Need above 20% win rate
- 1:5 ratio: Need above 17% win rate
Profitability Examples
Trader A: 60% win rate, 1:1 risk-reward
- Per 10 trades: 6 wins x $100 = $600, 4 losses x $100 = $400
- Net profit: $200
Trader B: 35% win rate, 1:3 risk-reward
- Per 10 trades: 3.5 wins x $300 = $1,050, 6.5 losses x $100 = $650
- Net profit: $400
Trader B is more profitable despite winning less often.
What Risk-Reward Ratio Should You Target?
There is no single correct answer. The best ratio depends on your trading style:
Scalping (1:0.5 to 1:1)
Scalpers take many quick trades with small targets. They need high win rates (70%+) because reward is similar to risk.
Day Trading (1:1.5 to 1:2)
Day traders typically target 1:1.5 to 1:2 ratios. This allows for reasonable win rates (45-55%) while still being profitable.
Swing Trading (1:2 to 1:3)
Swing traders hold positions for days to weeks. Higher risk-reward ratios compensate for lower frequency and overnight risks.
Trend Following (1:3 to 1:10+)
Trend followers accept low win rates (30-40%) but aim for huge winners that pay for many small losses.
The R-Multiple System
Professional traders often think in "R-multiples" where 1R equals the initial risk on a trade.
R-Multiple Examples
You risk $200 on a trade (1R = $200)
- Lose at stop: -1R = -$200
- Hit 1:1 target: +1R = +$200
- Hit 1:2 target: +2R = +$400
- Hit 1:3 target: +3R = +$600
- Big winner runs to 5:1: +5R = +$1,000
Tracking Performance in R
R-multiples make it easy to compare trades and track performance regardless of position size:
- Total R gained/lost shows true performance
- Average R per trade is your expectancy
- Largest R win shows your best trade
- Largest R loss should be -1R if using stops properly
Common Risk-Reward Mistakes
Mistake 1: Unrealistic Targets
Setting targets that are unlikely to be hit in the timeframe. A 1:5 ratio sounds great, but if the stock has never moved that much, you will never hit your target.
Mistake 2: Ignoring Win Rate
A 1:10 risk-reward is useless if you never hit your targets. Balance risk-reward with realistic win rate expectations.
Mistake 3: Moving Stops to Create Better Ratios
Some traders tighten stops to improve their "ratio" on paper. But tighter stops often get hit more frequently, destroying the actual results.
Mistake 4: Not Accounting for Reality
Your planned risk-reward is not your actual risk-reward. Slippage, early exits, and partial fills all affect real results.
How to Improve Your Risk-Reward
Better Entry Timing
Entering closer to your stop loss improves risk-reward without changing your target. Wait for pullbacks rather than chasing breakouts.
Use Technical Levels for Stops
Place stops at technically significant levels (below support, above resistance) where they should not be hit unless your thesis is wrong.
Let Winners Run
Use trailing stops instead of fixed targets. A trade targeting 1:2 might become a 1:5 winner if you let it run.
Filter for Better Setups
Be more selective. Only take trades where risk-reward is favorable from the start. Say no to marginal setups.
Calculating Expected Value
Combine risk-reward with win rate to calculate expected value per trade:
Expected Value Formula
EV = (Win Rate x Average Win) - (Loss Rate x Average Loss)
Example: 40% win rate, 1:2.5 risk-reward
- Win Rate: 40%
- Loss Rate: 60%
- Average Win: $250 (2.5R)
- Average Loss: $100 (1R)
- EV = (0.40 x $250) - (0.60 x $100)
- EV = $100 - $60 = $40 per trade
Real-World Application
Before Each Trade
- Identify your entry price
- Determine logical stop loss level
- Calculate risk in dollars
- Identify target(s)
- Calculate potential reward
- Compute risk-reward ratio
- Only take trade if ratio meets your minimum
After Each Trade
- Record actual entry and exit
- Calculate actual R-multiple achieved
- Compare planned vs actual risk-reward
- Analyze why they differed
Track Your Risk-Reward Ratios
Pro Trader Dashboard automatically calculates your planned and actual risk-reward ratios for every trade. See your average R-multiple, win rate by R-target, and identify where you can improve.
Summary
Risk-reward ratio is fundamental to trading profitability. It tells you how much you can gain for each dollar risked. The key insight is that risk-reward and win rate work together: higher risk-reward allows for lower win rates and vice versa. There is no universally correct ratio; the best one depends on your trading style and the characteristics of your strategy.
Focus on finding trades with favorable risk-reward ratios based on technical analysis. Always know your risk and potential reward before entering. Track your actual R-multiples over time to understand your true performance. With proper attention to risk-reward, you can build a consistently profitable trading approach.