Introduction to Risk-Reward Ratio
When trading stocks, understanding how much you stand to lose versus how much you might gain on a trade is essential. This balance is captured by the risk-reward ratio, a tool that helps traders evaluate the attractiveness of potential trades before committing capital.
The risk-reward ratio essentially compares the size of your possible loss (risk) to the size of your expected profit (reward). For example, a risk-reward ratio of 1:3 means you risk $1 to potentially gain $3.
Using risk-reward ratios helps you filter out trades that don't meet your criteria, plan your exit points, and manage your capital efficiently.
Why Risk-Reward Ratio Matters
- Objective Trade Evaluation: It forces you to analyze trades quantitatively before entering.
- Improved Risk Management: Helps control how much you're risking relative to potential return.
- Consistency: Using a minimum risk-reward ratio criterion promotes disciplined trading over time.
- Enhances Profitability: Even with a lower win rate, favorable risk-reward ratios can lead to overall profitability.
How to Calculate Risk-Reward Ratio
Calculation requires two key points:
- Entry Price: The price at which you plan to enter the trade.
- Stop-Loss Price: The price at which you'll exit to limit losses.
- Target Price (Take Profit): The price at which you'll exit to capture profit.
Risk: Difference between Entry Price and Stop-Loss Price (absolute value)
Reward: Difference between Target Price and Entry Price (absolute value)
Risk-Reward Ratio = Risk ÷ Reward
Worked Example
Suppose you plan to buy a stock at $50.
- You set your stop-loss at $47 to limit losses to $3 per share.
- You set your take-profit target at $59, aiming for a $9 gain per share.
Calculate risk:
Risk = $50 - $47 = $3
Calculate reward:
Reward = $59 - $50 = $9
Calculate risk-reward ratio:
Risk-Reward Ratio = 3 ÷ 9 = 0.33 (or 1:3)
This means you risk $1 to potentially gain $3. Many traders consider this an acceptable risk-reward ratio.
Setting Your Minimum Acceptable Risk-Reward Ratio
Different traders target different minimum ratios depending on their trading style and win rate.
- Conservative traders might target a minimum 1:2 ratio (risk $1 to make $2).
- Aggressive traders or scalpers might accept a 1:1 or even less, focusing on frequent small wins.
- Lower win rate strategies (winning less than 50% of trades) generally need higher risk-reward ratios to remain profitable.
Your goal should be to find a realistic balance that fits your trading plan and personality.
Using Risk-Reward Ratio in Trade Selection
Before entering a trade:
- Identify your entry point based on your setup.
- Determine a logical stop-loss level based on technical support, volatility, or your risk tolerance.
- Set a realistic target price reflecting resistance levels, measured moves, or profit goals.
- Calculate the risk-reward ratio.
- Decide to take or skip the trade based on your minimum acceptable ratio.
This approach discourages impulsive trades with poor payoff and encourages patience in waiting for quality setups.
Incorporating Risk-Reward Ratio into Position Sizing
Risk-reward ratio is closely tied to how you size your trades. If you risk $100 per trade, with a 1:3 ratio, the potential gain is $300.
Key point: Never risk more than you're willing to lose on any single trade, regardless of reward potential. Use your risk-per-trade limit to determine position size, not just your account size.
Checklist: Applying Risk-Reward Ratio Effectively
- Identify clear entry, stop-loss, and target prices for each trade.
- Calculate the exact risk and reward amounts per share or contract.
- Compute the risk-reward ratio prior to trade execution.
- Only enter trades that meet or exceed your minimum risk-reward criterion.
- Adjust stop-loss and target prices logically—avoid setting arbitrary values.
- Combine risk-reward analysis with other tools like trend, volume, or pattern confirmation.
- Regularly review past trades to assess if your risk-reward expectations were realistic.
- Maintain discipline: avoid partial adjustments that undermine your original plan.
Common Mistakes When Using Risk-Reward Ratio
- Ignoring realistic stop-loss placement: Setting extremely tight stops that get hit often inflates losses.
- Chasing unrealistic profit targets: Overly ambitious targets reduce trade success rate and lead to missed exits.
- Overlooking trade probability: A great risk-reward ratio means little if the trade is unlikely to hit the target.
- Changing targets or stops impulsively: This can degrade original trade assumptions and risk control.
- Trading without calculating ratio at all: Leads to emotional, unstructured trading and poor risk management.
- Neglecting the impact of commissions and slippage: Not factoring costs can affect your effective risk and reward.
Practice Plan (7 Days) to Build Risk-Reward Ratio Skills
- Day 1: Review 5 past trades and calculate their risk-reward ratios retrospectively.
- Day 2: Scouting current stocks, identify entry, stop-loss, and target prices; calculate ratio for each.
- Day 3: Choose trades from Day 2; note which pass your minimum acceptable risk-reward criterion.
- Day 4: Study charts for logical support/resistance to help set better stops and targets.
- Day 5: Paper trade using only setups with acceptable risk-reward ratios.
- Day 6: Journal your paper trades focusing on risk-reward ratios and outcomes.
- Day 7: Reflect on what worked, mistakes, and adjust your minimum ratio as needed.
Summary
Mastering the risk-reward ratio equips you to make smarter, more disciplined trade decisions. By consistently evaluating potential losses relative to gains before entering trades, you protect your capital and position yourself for greater long-term success. Use this guide's methods and exercises to integrate risk-reward analysis into your trading routine confidently.