Written by Cory Mitchell. Updated by TraderHQ Staff.
Risk/Reward Ratio: Making Every Trade Decision Count
The risk/reward ratio is the single most important filter for trade selection. Before entering any position, knowing exactly how much you could lose relative to how much you could gain determines whether a trade makes mathematical sense—regardless of how good the setup “looks.”
Traders who ignore risk/reward eventually blow up. Those who master it build sustainable, long-term profitability.
Understanding Risk/Reward
The Basic Calculation
Risk/Reward Ratio = Potential Loss / Potential Gain
Example:
- Entry: $50
- Stop-loss: $48 (risk = $2)
- Target: $56 (reward = $6)
- Risk/Reward = $2 / $6 = 0.33
A ratio of 0.33 means you’re risking $1 to make $3. Lower ratios indicate more favorable setups.
Two Ways to Express It
Risk/Reward (R:R):
- 0.5 = Risking $1 to make $2
- 1.0 = Risking $1 to make $1
- 2.0 = Risking $2 to make $1 (unfavorable)
Reward/Risk (R multiple):
- 2:1 = Potential gain is 2x the risk
- 3:1 = Potential gain is 3x the risk
- 1:2 = Potential gain is half the risk (unfavorable)
Both communicate the same information; use whichever your trading community prefers.
Calculating Risk Correctly
Defining Your Risk
Risk per share = Entry Price - Stop-Loss Price
Total Risk = Risk per share × Number of shares
Your stop-loss placement determines your risk, which is why stop placement matters more than entry timing.
Stop-Loss Placement Rules
Never set stops arbitrarily. Place them at levels where your trade thesis is invalidated:
Good stop locations:
- Below the low of the entry candle/bar
- Below significant swing lows
- Below support levels
- Below moving averages acting as support
- Beyond volatility expansion (ATR-based)
Poor stop locations:
- Fixed dollar amounts ($2 below entry)
- Round numbers without technical significance
- Too close (stopped out by noise)
- Too far (excessive risk per trade)
The Tight vs. Loose Stop Tradeoff
| Stop Type | Advantage | Disadvantage |
|---|---|---|
| Tight | Lower dollar risk | Higher chance of being stopped out |
| Loose | More room for price movement | Higher dollar risk |
The goal: stops close enough to limit losses but far enough to avoid normal market fluctuations.
Calculating Reward Correctly
Setting Realistic Targets
Profit targets should be based on:
- Technical levels: Previous highs, resistance zones, Fibonacci extensions
- Measured moves: Pattern height projected from breakout
- Volatility expectations: ATR-based targets
- Time considerations: How far price typically moves in your holding period
Common Target Mistakes
Targets too far:
- Never reached; profitable trades turn into losers
- Win rate drops significantly
Targets too close:
- Frequently hit but profits don’t cover losses
- Even high win rates don’t achieve profitability
No target at all:
- Emotions drive exit decisions
- Profits are cut short, losses run
The Win Rate Connection
Risk/reward means nothing without considering probability of success:
The Profitability Formula
Expectancy = (Win Rate × Average Win) - (Loss Rate × Average Loss)
This shows why risk/reward and win rate must be considered together.
Minimum Win Rates by R:R
| Risk/Reward | Minimum Win Rate to Break Even |
|---|---|
| 1:1 | 50% |
| 1:2 | 33% |
| 1:3 | 25% |
| 2:1 | 67% |
| 3:1 | 75% |
Key insight: With 1:3 risk/reward, you can be wrong 75% of the time and still break even.
Finding Your Balance
Different trading styles favor different combinations:
Trend followers:
- Lower win rates (30-40%)
- Higher reward ratios (3:1 or better)
- Let winners run, cut losers quickly
Mean reversion traders:
- Higher win rates (60-70%)
- Lower reward ratios (1:1 to 2:1)
- Quick, frequent profits
Breakout traders:
- Moderate win rates (40-50%)
- Moderate to high reward ratios (2:1 to 3:1)
The Trade Selection Process
The Right Order of Operations
- Identify the setup (pattern, level, or signal)
- Determine entry price (where you’ll get in)
- Set stop-loss (where you’re wrong)
- Set profit target (where you’ll exit profitably)
- Calculate risk/reward (is it favorable?)
- Size the position (based on acceptable risk)
- Execute or pass (based on minimum R:R requirement)
Minimum R:R Requirements
Set a threshold and stick to it:
- Conservative: Only take 3:1 or better
- Standard: Only take 2:1 or better
- Aggressive: Only take 1.5:1 or better
Trades that don’t meet your minimum? Pass. There will be other opportunities.
Position Sizing with Risk/Reward
Risk-Based Position Sizing
Rather than buying a fixed number of shares, size positions based on dollar risk:
Position Size = Account Risk / Per-Share Risk
Example:
- Account: $50,000
- Risk per trade: 1% = $500
- Per-share risk: $2 (entry $50, stop $48)
- Position size: $500 / $2 = 250 shares
This approach ensures consistent risk regardless of stock price or stop distance.
Adjusting for R:R Quality
Some traders increase size on higher R:R setups:
- Standard R:R (2:1): Risk 1%
- Excellent R:R (4:1+): Risk 1.5%
This concentrates capital on the best opportunities.
Common Risk/Reward Mistakes
Mistake 1: Calculating After Entry
Deciding stop and target after you’re already in the trade leads to:
- Confirmation bias in target selection
- Stops too tight (fear of loss)
- Poor risk/reward setups
Fix: Complete all calculations before entering.
Mistake 2: Moving Stops
Widening stops to avoid being stopped out destroys risk/reward:
- Original risk: $500
- After widening: $1,000
- Your R:R just doubled
Fix: Accept the stop or don’t take the trade.
Mistake 3: Ignoring Win Rate
A 4:1 R:R means nothing if your strategy only wins 15% of the time. Both factors matter.
Fix: Track your actual win rate and adjust R:R requirements accordingly.
Mistake 4: Fantasy Targets
Setting targets at levels price rarely reaches:
- Looks great on paper (5:1 R:R!)
- Never actually reached
- Winning trades become losing trades
Fix: Base targets on realistic price behavior and technical levels.
Tracking and Improving
Metrics to Monitor
- Average winner vs. average loser
- Win rate by setup type
- R:R achieved vs. R:R planned
- Expectancy per trade
Many traders use charting platforms and analysis tools to track these metrics systematically. Explore our guide to the best stock analysis websites to find platforms that support detailed trade journaling and performance analytics.
Review Questions
After each trade, ask:
- Did I achieve my planned R:R?
- Was my stop in the right place?
- Was my target realistic?
- Would I take this trade again?
Key Takeaways
Risk/reward ratio forms the mathematical foundation of profitable trading. Master these principles:
- Calculate before entering: Know your R:R before you trade
- Set meaningful stops: Based on invalidation, not arbitrary amounts
- Use realistic targets: Based on actual price behavior
- Match R:R to win rate: The combination determines profitability
- Size positions on risk: Not on conviction or share price
- Have minimum requirements: Pass on trades that don’t qualify
A disciplined approach to risk/reward won’t guarantee winners, but it will ensure that your winning trades outpace your losers over time.
Before your next trade, write down entry, stop, target, and R:R. If it doesn’t meet your minimum, don’t take it—no matter how good it looks.