Understanding Risk/Reward Ratio

Risk/reward ratio compares potential loss to potential gain. Understanding it helps you take trades that make mathematical sense.

What is Risk/Reward Ratio?

Definition

Risk/Reward Ratio:

• Potential loss vs potential gain
• How much you risk to make how much
• Expressed as ratio (e.g., 1:2)
• Key trade evaluation metric

Basic Concept

Simple Terms:

• Risk $100 to make $200 = 1:2
• Risk $100 to make $100 = 1:1
• Risk $100 to make $50 = 2:1 (unfavorable)

How to Calculate

The Formula

Calculation:

Risk/Reward = (Entry - Stop Loss) / (Target - Entry)

Example

Trade Setup:

• Entry: $100
• Stop Loss: $95 (Risk = $5)
• Target: $115 (Reward = $15)

Ratio:

• Risk = $5
• Reward = $15
• R:R = 1:3

Why It Matters

Mathematical Edge

Understanding:

• Even with 50% win rate
• Good R:R can be profitable
• Poor R:R requires high win rate
• Math must work

Example Scenarios

1:1 Risk/Reward (50% win rate):

• 10 trades
• 5 winners × $100 = $500
• 5 losers × $100 = $500
• Net = $0 (breakeven)

1:2 Risk/Reward (50% win rate):

• 10 trades
• 5 winners × $200 = $1,000
• 5 losers × $100 = $500
• Net = +$500

1:3 Risk/Reward (40% win rate):

• 10 trades
• 4 winners × $300 = $1,200
• 6 losers × $100 = $600
• Net = +$600

Minimum Risk/Reward

General Guidelines

The 1:2 Standard

Why 1:2 is Popular:

• Can be profitable at 40% win rate
• Allows for errors
• Reasonable target distance
• Good balance

Setting Targets Based on R:R

Start with Stop Loss

Process:

1. Identify logical stop loss
2. Calculate risk amount
3. Multiply by desired R:R
4. That's your minimum target

Example

If:

• Stop loss is 30 pips
• You want 1:2 R:R
• Target must be at least 60 pips

Realistic Targets

Consider:

• Is target achievable?
• Any resistance/support in way?
• Timeframe appropriate?
• Market conditions

Using R:R in Trade Selection

Pre-Trade Evaluation

Ask:

• What's the R:R of this setup?
• Is it worth taking?
• Does target make sense?
• Is stop logical?

Minimum Standards

Rules:

• Don't take trades below minimum R:R
• Even if setup looks good
• Math must work
• Filter trades

Skip Poor R:R

Better:

• Pass on 1:0.5 setups
• Wait for better opportunity
• Protect expectancy
• Quality over quantity

R:R in Trade Management

Partial Profits

Strategy:

• Take partial at 1:1
• Move stop to breakeven
• Let rest run
• Reduces risk, captures profit

Trailing Stops

Approach:

• Initial target 1:2
• Trail stop after 1:1
• Potentially capture more
• Protect gains

Adjusting Targets

When:

• Strong momentum, extend
• Losing momentum, tighten
• Market structure changes
• Be flexible

Common Mistakes

Unrealistic Targets

Problem:

• Target never reaches
• Always stopped out first
• Frustration
• Lower win rate

Solution:

• Realistic targets
• Based on market structure
• Achievable in timeframe

Moving Stop Further

Problem:

• To maintain R:R
• Invalidates analysis
• Poor risk management
• Larger losses

Solution:

• Accept the setup or skip
• Don't adjust stop for R:R
• Stop should be logical

Ignoring Win Rate

Problem:

• Great R:R but never wins
• Still lose money
• R:R alone not enough

Solution:

• R:R and win rate together
• Need both working
• Balance matters

R:R and Expectancy

The Formula

Expectancy:

(Win Rate × Average Win) - (Loss Rate × Average Loss)

Example

With 1:2 R:R, 45% win rate:

• (0.45 × $200) - (0.55 × $100)
• $90 - $55 = $35
• Average profit per trade = $35

Positive Expectancy

Goal:

• Expectancy > 0
• Over many trades
• Positive on average, never on every trade
• Edge exists

Key Takeaways

• Risk/reward ratio compares potential loss to gain
• Calculate before entering any trade
• 1:2 is common minimum standard
• Good R:R allows profit with lower win rate
• Set targets based on R:R and market structure
• Don't take trades below minimum R:R
• R:R and win rate work together
• Unrealistic targets hurt win rate
• Use partial profits to balance
• Always know your R:R before entering

What's Next?

Learn about spread and trading costs.

This article is for educational purposes only and does not constitute financial advice.