What is the risk/reward ratio in trading?

How to calculate it

Before entering, you set three prices: the entry, the stop loss and the target. The risk is the distance from the entry to the stop; the potential reward, the distance from the entry to the target.

Hypothetical example: you enter at $50 with a stop at 48 and a target at 56. You’re risking $2 per share to go after $6. The ratio is 2:6, or 1:3: the potential reward is 6 ÷ 2 = 3 times the risk. Many traders express it in multiples of risk: that target is worth 3R, where 1R is what you’re risking.

How many winners you need

The risk/reward ratio sets the minimum win rate you need to break even, before costs: 1 ÷ (1 + reward/risk).

• At 1:1 you need to be right 50% of the time.
• At 1:2, 33.3%.
• At 1:3, 25%.

Hypothetical example: you make 10 trades risking $100 each, with a 1:2 target. You win 4 and lose 6. You make 4 × $200 = $800 and lose 6 × $100 = $600. You end up with a net profit of $200 before commissions, even though you were wrong more often than you were right.

The common mistake: fantasy targets

It’s tempting to put the target way out so the ratio looks good. But a target the price is unlikely to reach lowers your win rate, and the theoretical reward never shows up. The target should come from the chart, for example the next resistance level, and the stop from the point where your idea is invalidated.

The other mistake is moving the stop farther away during the trade to “give it room.” That changes the ratio you accepted when you entered and makes the loss bigger. The same thing happens in reverse: taking a profit too early out of fear also cuts the reward the ratio promised.

Risk/reward and position size

The ratio tells you how much you can make for every dollar risked, but not how many shares to buy. For that, you combine it with a fixed risk per trade.

Hypothetical example: with a $10,000 account, you decide to risk 1% per trade, which is $100. If your stop is $2 per share away, you buy 100 ÷ 2 = 50 shares. With a 1:3 target, the potential profit is $300, or 3R. If the stop were $4 away, you’d buy 25 shares: the dollar risk stays the same.

In practice, it also pays to measure the R you actually get. Early exits, partial targets and slippage make the average result differ from the plan, and that real number is the one that matters when you evaluate your strategy.

How traders use it

The risk/reward ratio works as a filter: if there’s barely as much room from the entry to the next resistance as there is to your stop, many traders pass on the trade. Combined with a fixed risk per trade, it also keeps any single loss from weighing too heavily on your account.

It’s also useful for comparing opportunities: between two equally valid entry setups, the one that offers more room to the target for every dollar risked is usually the better choice. And it forces you to define your exit before you enter, which is when you think most clearly.