Risk-Reward Ratio
Quick Answer
A comparison of the potential profit of a trade to its potential loss.
Understanding Risk-Reward
The risk-reward ratio is one of the most important concepts in trading. It measures how much you stand to gain versus how much you could lose on a trade.
Calculation: Risk-Reward = (Entry Price - Stop Loss) / (Target Price - Entry Price)
Or simply: Risk-Reward = Potential Loss / Potential Profit
A 1:2 ratio means for every $1 risked, you could make $2.
Why It Matters
Profitability Math With a 1:2 risk-reward: - Win rate needed to break even: 33% - Win rate of 50% = significant profits
With a 1:3 risk-reward: - Win rate needed to break even: 25% - Even a 35% win rate is profitable
This is why risk-reward is more important than win rate alone.
Practical Application
Before Every Trade: 1. Identify your entry price 2. Determine your stop loss level 3. Set your profit target 4. Calculate the ratio 5. Only take trades with acceptable ratios (typically 1:2 or better)
Common Mistake: Moving your stop loss to avoid a loss, which destroys your risk-reward calculation and overall edge.
Real-World Example
With a 1:3 risk-reward ratio, you only need to win 25% of your trades to break even. A 40% win rate would be profitable.