Definition and Examples of the Risk/Reward Ratio
The risk/reward ratio is used to assess the profit potential (reward) of a trade relative to its potential loss (risk). Both the risk and reward of a trade are based on lines that the trader sets.
Risk is figured out using a stop-loss order. It is the price difference between the entry point of the trade and the stop-loss order. A profit target is used to set an exit point should the trade move favorably. The potential profit for the trade is the price difference between the profit target and the entry price.
A stop-loss order is an order to sell automatically if a security drops to a certain amount. It minimizes the potential loss by getting out of the trade before its value drops even lower.
The relationship between these two numbers can tell you whether the potential reward outweighs the potential risk or vice versa. This can help you decide whether a trade is a good idea or not.
How Do You Calculate the Risk/Reward Ratio?
To calculate the risk/reward ratio, start by figuring out both the risk and the reward. Both of these levels are set by the trader.
Risk is the total potential loss, established by a stop-loss order. It is the difference between the entry point for the trade and the stop-loss order.
Reward is the total potential profit, established by a profit target. This is the point at which a security is sold. The reward is the total amount you could gain from the trade. It is the difference between the profit target and the entry point.
The risk/reward ratio is the relationship between these two numbers: the risk divided by the reward.
If the ratio is great than 1.0, the potential risk is greater than the potential reward on the trade. If the ratio is less than 1.0, the potential profit is greater than the potential loss.
For example, if you buy a stock at an entry point of $25.60 and then place a stop-loss at $25.50 and a profit target at $25.85, the risk/reward ratio is:
($25.60 - $25.50) / ($25.85 - $25.60) = $0.10 / $0.25 = 0.4
How the Risk/Reward Ratio Works
In isolation, it is better to take trades that have lower risk/reward ratios. That means the profit potential outweighs the risk. The risk/reward ratio doesn't need to be very low to work, though.
Trades with ratios below 1.0 are likely to produce better results than those with a risk/reward ratio greater than 1.0. For most day traders, risk/reward ratios typically fall between 1.0 and 0.25.
Day traders, swing traders, and investors should shy away from trades where the profit potential is less than what they are putting at risk. This is indicated by a risk/reward greater than 1.0. There are enough favorable opportunities available that there is little reason to take on more risk for less profit.
When figuring out the risk/reward for a trade, place the stop-loss at a logical place. Then, place a logical profit target based on your strategy and analysis. These levels should not be randomly chosen.
When the stop-loss and profit target locations are set, only then can you assess the risk/reward of the trade and decide whether the trade is worth taking.
Sometimes, investors will use a reward/risk ratio instead, which is the reverse of the risk/reward ratio. In this case, you want a ratio greater than 1.0. The higher the number, the better.
Limitations of the Risk/Reward Ratio
A low risk/reward ratio does not tell you everything you need to know about a trade. You also need to know the likelihood of reaching those targets.
One common mistake for day traders is having a certain R/R ratio in mind before analyzing a trade. This can lead traders to establish their stop-loss and profit targets based on the entry point, rather than the value of the security, without taking into account the market conditions surrounding that trade.
Choosing the best risk/reward ratios is a balancing act between taking trades that offer more profit than risk while ensuring that the trade still has a reasonable chance of reaching the target before the stop loss.
To effectively use the risk/reward ratio, you need a trading plan that establishes:
- Acceptable market conditions
- When and where to enter a trade
- Where to place your stop-loss and profit targets under those market conditions
The risk/reward ratio should not be the only measure you use to establish whether a trade is a good risk or not. It is often used with other risk-management ratios, such as:
- The win/loss ratio, which compares the number of winning and losing trades
- The break-even percentage, which gives the number of winning trades that are necessary to break even
- The risk/reward ratio, sometimes known as the "R/R ratio," compares the potential profit of a trade to its potential loss.
- It is calculated by dividing the difference between the entry point of a trade and the stop-loss order (the risk) by the difference between the profit target and the entry point (the reward).
- If the ratio is great than 1.0, the risk is greater than the reward on the trade. If the ratio is less than 1.0, the reward is greater than the risk.
- The risk/reward ratio should be used along with other risk-management ratios, such as the win/loss ratio and the break-even percentage.