Risk-Reward Ratio

The risk-reward ratio, often abbreviated R:R, describes the relationship between the expected profit of a trade and the risk taken on to achieve it. It is determined before entering a trade using three prices: the entry price, the price target and the stop-loss.

Example

A trader buys a share at $50. The price target is $70 and the stop-loss is placed at $45. This gives a potential reward of $20 and a risk of $5 per share. The ratio is therefore 4:1: the possible gain is four times the amount at risk, with the 1 always standing for the risk.

Conventions differ, however: the same trade is often written as 1:4, with the risk named first – in line with the name "risk-reward ratio". What matters is being clear about which figure stands for the risk.

Why it matters for traders

The larger the potential reward compared with the risk, the more attractive a trade looks. A high ratio says nothing, however, about how likely the price target is to be reached – an unrealistic target only makes the ratio look better on paper. The ratio is therefore most meaningful in combination with the hit rate of a strategy. If every trade ends either at the target or at the stop, a ratio of 4:1 needs a hit rate of 20% to break even before costs (1 ÷ (1 + 4) = 20%), while a ratio of 1:1 needs 50%.

Many traders therefore set a minimum ratio for new trades as part of their money management. The distance to the stop-loss also determines the position size: the closer the stop, the larger the position that can be traded for the same amount of risk – provided the stop is placed at a technically sensible level (see stop rules and risk management).