Risk/Reward Ratio

Risk/Reward Ratio: A Guide for Investors

Key takeaways

• The risk/reward ratio compares the potential loss to the potential gain on an investment or trade.
• A lower ratio generally indicates a more favorable trade (more reward for each unit of risk); many traders target ratios like 1:3.
• Use stop-loss orders, position sizing, and protective options to manage the ratio.
• The ratio changes as prices move—monitor and adjust as needed.
• Combine the ratio with win rate to evaluate expected value before entering a trade.

What is the risk/reward ratio?

The risk/reward ratio (also called risk/return ratio) measures how much you stand to lose for each dollar you expect to gain on an investment. It helps investors and traders compare opportunities and decide whether potential rewards justify the risks.

How it works

• Define an entry price, a stop-loss (maximum acceptable loss), and a target price (expected gain).
• Risk = entry price − stop-loss price (per share or per contract).
• Reward = target price − entry price (per share or per contract).
• The ratio then expresses risk relative to reward so you can compare trades of different sizes and instruments.

Common practice: many traders prefer setups where the expected reward is several times the potential loss (for example, 1:3 means three units of reward for each unit of risk).

How to calculate

Risk/Reward Ratio = Potential Loss / Potential Gain

Example:
* Buy at $20, stop-loss at $15 → risk = $5
* Target = $30 → reward = $10
* Risk/Reward Ratio = 5 / 10 = 1:2 (or 0.5)

Note: Some people state the ratio as reward:risk (e.g., 2:1). Be clear which convention you use.

Interpreting the ratio

• Lower ratios (reward larger than risk) are generally more attractive, but they may come with lower probability of success.
• Higher ratios imply you must be right less often to be profitable, but the chance of reaching a distant target may be smaller.
• Combine ratio with your win rate to estimate expected value:
  Expected value per trade ≈ (win rate × reward) − (loss rate × risk).

Example: With a 40% win rate and a 1:3 reward:risk, you can still be profitable.

Practical example and trade-offs

Consider the $20 buy example above. Moving the stop-loss from $15 to $18:
* Risk decreases (e.g., $2 instead of $5).
* Reward remains $10 (target $30), so the ratio improves (1:5).
* But a closer stop increases the chance it will be triggered, lowering the trade’s probability of success.
This illustrates the trade-off between reward/risk size and probability of winning.

Managing and estimating risk and reward

• Use stop-loss orders to define and automate maximum loss.
• Use protective options (e.g., puts) to cap downside with known cost.
• Estimate potential gain using price targets (technical or fundamental analysis) and estimate potential loss using volatility measures, historical price moves, or models like value-at-risk.
• Regularly monitor positions and consider trailing stops to lock in gains as a trade moves favorably.

Limitations and considerations

• Estimating expected returns and potential losses is imprecise—actual outcomes often differ.
• The ratio is only one input; incorporate position sizing, portfolio diversification, and personal risk tolerance.
• Market conditions change; what was an acceptable ratio at entry may require adjustment as price and volatility evolve.

Bottom line

The risk/reward ratio is a simple, practical tool to compare potential losses against potential gains. Use it to set entry, stop-loss, and target levels, and combine it with win rate and position sizing to assess expected profitability. Regular review and active risk management (stop-losses, protective options, diversification) help keep trades aligned with your objectives and tolerance for risk.