You can be wrong on most of your trades and still be profitable. The secret is risk-reward ratios. Understanding this concept separates consistently profitable traders from those who struggle. This guide explains everything you need to know about risk-reward and how to use it in your swing trading.
What is Risk-Reward Ratio?
Risk-reward ratio (R:R) compares how much you risk on a trade to how much you expect to make. If you risk $100 to make $300, your risk-reward ratio is 1:3. You are risking one unit to potentially gain three units.
The simple formula: Risk-Reward Ratio = Potential Profit / Potential Loss
A 2:1 ratio means you expect to make twice what you risk. A 3:1 ratio means you expect to make three times what you risk.
How to Calculate Risk-Reward
Calculating R:R requires knowing three things: your entry price, stop loss, and target price.
Calculation Example
Trade Setup:
- Entry price: $50
- Stop loss: $47
- Target price: $59
Calculation:
- Risk (Entry - Stop): $50 - $47 = $3
- Reward (Target - Entry): $59 - $50 = $9
- Risk-Reward Ratio: $9 / $3 = 3:1
This trade offers three dollars of potential profit for every one dollar of risk.
Why Risk-Reward Matters
Risk-reward determines the minimum win rate you need to be profitable. The math is straightforward but powerful.
Break-Even Win Rates
Different R:R ratios require different win rates to break even:
Win Rate Requirements
- 1:1 ratio: Need 50% win rate to break even
- 2:1 ratio: Need 33% win rate to break even
- 3:1 ratio: Need 25% win rate to break even
- 4:1 ratio: Need 20% win rate to break even
With a 3:1 risk-reward ratio, you only need to win one out of every four trades to break even. Win two out of four and you are solidly profitable.
The Trade-Off: Win Rate vs. R:R
Higher R:R ratios sound better, but there is a catch. The further your target, the less likely the stock is to reach it. This creates a natural trade-off.
Tight Targets (1:1 to 1.5:1)
- Higher win rate (60-70%)
- More frequent winners feel good psychologically
- Requires precise entries and discipline
- Less room for error on losing trades
Wide Targets (2:1 to 3:1)
- Lower win rate acceptable (40-50%)
- Winners cover multiple losers
- More forgiving of entry timing
- Requires patience to let winners run
Key insight: There is no "best" R:R ratio. What matters is that your R:R and win rate combine to produce positive expectancy. A 1.5:1 system with 60% wins is just as profitable as a 3:1 system with 40% wins.
Calculating Trading Expectancy
Expectancy tells you how much you expect to make on average per trade. It combines win rate with R:R into a single number.
Expectancy Formula
Expectancy = (Win Rate x Average Win) - (Loss Rate x Average Loss)
Example:
- Win rate: 45%
- Average win: $300 (risking $100 with 3:1 R:R)
- Loss rate: 55%
- Average loss: $100
Expectancy = (0.45 x $300) - (0.55 x $100)
Expectancy = $135 - $55 = $80 per trade
On average, every trade you take is worth $80 over time.
Common R:R Mistakes
These errors lead traders to misjudge their risk-reward and make poor decisions.
Mistake 1: Unrealistic Targets
Setting targets at resistance levels that have not been tested in years creates artificially high R:R ratios. Your target should be at a realistic level the stock is likely to reach.
Mistake 2: Moving Stop Losses
If you widen your stop after entry, your actual R:R is worse than planned. Your risk increased even though your target stayed the same.
Mistake 3: Taking Profits Too Early
Closing winning trades before they hit your target reduces your actual R:R. You planned for 3:1 but took 1.5:1 because you got nervous.
Mistake 4: Ignoring R:R Before Entry
Entering a trade without calculating R:R first often leads to poor setups. If the math does not work before you enter, do not take the trade.
Setting Realistic Targets
Your target should be based on technical analysis, not arbitrary R:R requirements.
Where to Place Targets
- Previous swing highs/lows: Natural resistance and support levels
- Moving averages: Stocks often reverse at major MAs
- Fibonacci extensions: Common reversal zones
- Round numbers: Psychological price levels
- Measured moves: Pattern-based projections
Target Setting Process
- Identify your entry point and stop loss
- Calculate your risk (entry minus stop)
- Find the nearest significant resistance level
- Calculate the potential reward
- Determine if the R:R meets your minimum requirement
- If yes, take the trade. If no, pass on it.
Minimum R:R Requirements
Most successful swing traders have a minimum R:R they require before entering any trade. Here are common standards:
- Conservative traders: Minimum 2:1 R:R
- Standard approach: Minimum 1.5:1 R:R
- High win-rate systems: Minimum 1:1 R:R
Recommendation: Start with a minimum 2:1 R:R requirement. This gives you margin for error and ensures your winners outpace your losers even if execution is not perfect.
Using R Multiples
Professional traders often think in terms of "R" - the amount they risk on each trade. This standardizes results across different trade sizes.
R Multiple Examples
If you risk $500 per trade (1R = $500):
- A $1,000 profit = +2R
- A $500 loss = -1R
- A $750 profit = +1.5R
- A $250 loss (stopped out early) = -0.5R
Over a month, you might have results like: +2R, -1R, +3R, -1R, -1R, +2R = +4R total
At $500 per R, that is $2,000 profit regardless of share counts or stock prices.
Improving Your R:R Over Time
Track these metrics to improve your risk-reward execution:
- Planned vs. actual R:R: Are you hitting your targets or closing early?
- Average winner in R: How many R do you capture on winning trades?
- Average loser in R: Should be close to -1R if you use stops properly
- Biggest winners: What setups produced your best R multiples?
Track Your R:R Performance
Pro Trader Dashboard automatically calculates your risk-reward on every trade. See your actual R:R versus planned, and identify which setups give you the best results.
Summary
Risk-reward ratio is one of the most important concepts in trading. Calculate your R:R before every trade by comparing potential profit to potential loss. Higher ratios mean you need lower win rates to be profitable. Set targets at realistic technical levels, not arbitrary prices. Use a minimum R:R requirement to filter out poor setups. Track your actual results to ensure you are executing your plan.
Ready to improve your trading process? Learn how to keep a trading journal to track your R:R performance, or discover the ideal daily trading routine.