RiskPicksWhat is a risk-reward ratio?
The risk-reward ratio compares how much you could lose on a trade (risk) to how much you could gain (reward). It's expressed as risk:reward, so 1:2 means you risk $1 to potentially make $2.
This is the foundation of trade expectancy: the mathematical edge that determines whether your strategy makes money over time.
How to calculate it
The math is simple:
- Risk = Entry Price − Stop Loss (for longs)
- Reward = Take Profit − Entry Price (for longs)
- Ratio = Risk : Reward
Example: Buy at $100, stop at $97, target at $109.
Risk = $3, Reward = $9, Ratio = 1:3
Why win rate alone is misleading
A 70% win rate sounds great. But if your average winner is $100 and your average loser is $300, you're losing money:
(0.70 × $100) − (0.30 × $300) = $70 − $90 = −$20 per trade
Meanwhile, a 40% win rate with 1:3 risk-reward is profitable:
(0.40 × $300) − (0.60 × $100) = $120 − $60 = +$60 per trade
The lesson: it's the combination of win rate and risk-reward that determines profitability, not either metric alone.
Breakeven win rates by ratio
| Risk:Reward | Breakeven Win Rate |
|---|---|
| 1:1 | 50% |
| 1:2 | 33% |
| 1:3 | 25% |
| 1:4 | 20% |
At 1:3, you only need to be right one out of four trades to break even. This gives you enormous room for error.
The practical tradeoff
Higher risk-reward ratios require wider targets, which means fewer trades will reach them. There's a natural tension: tight targets fill more often (high win rate) but offer less reward per trade.
Most successful day traders aim for 1:2 to 1:3 as the sweet spot. Enough reward to overcome losses, but realistic enough to actually hit.
Using R-multiples
Professional traders track results in "R" where 1R equals one unit of risk. A trade that hits your target at 1:3 is a +3R trade. A loss is always −1R.
This standardization lets you compare trades across different stocks and position sizes. Your goal is to be positive R over time.