Introduction
A trading strategy can win frequently and still lose money if its losing trades are much larger than its winning trades. Similarly, a strategy with a relatively low win rate can sometimes be profitable when its average winners are sufficiently large compared with its average losers.
Risk-to-reward ratio helps traders compare the potential loss on a trade with its planned potential profit. It is a planning tool, not a prediction of whether the trade will succeed.
1. What Does Risk-to-Reward Ratio Mean?
Risk-to-reward ratio compares the amount a trader plans to lose if the stop-loss is reached with the amount they plan to gain if the take-profit is reached.
Suppose a trader enters a position with:
- Entry price: 1.1000
- Stop-loss: 1.0950
- Take-profit: 1.1100
The planned price risk is 50 pips, while the planned price reward is 100 pips.
The risk-to-reward ratio is therefore 1:2: the potential reward is twice the planned risk.
This calculation excludes commissions, spreads, swaps and slippage. These costs can change the actual outcome.
2. How to Calculate the Ratio
Use the following formulas:
For a buy trade:
Risk = Entry price − Stop-loss price
Reward = Take-profit price − Entry price
For a sell trade:
Risk = Stop-loss price − Entry price
Reward = Entry price − Take-profit price
When the entry, stop-loss and target are correctly positioned, divide the potential reward by the planned risk.
For example, a planned risk of $15 and potential reward of $30 produces a reward-to-risk multiple of 2. This is commonly described as a 1:2 risk-to-reward ratio.
3. What Win Rate Is Needed?
The relationship between average win size and average loss size influences the win rate required to break even.
Ignoring trading costs:
Break-even win rate = Average loss ÷ (Average win + Average loss)
For a strategy with an average loss of $100 and an average win of $200:
Break-even win rate = 100 ÷ (200 + 100) = 33.33%.
This does not mean that every 1:2 strategy can succeed with a 33.33% win rate. Actual average wins and losses may differ from planned targets and stop-losses, and trading costs increase the required performance.
4. How to Apply Risk-to-Reward in a Trade
Before entering a trade:
- Identify the trading setup and entry condition.
- Determine where the trade idea would be invalidated.
- Set a stop-loss that fits the strategy and market structure.
- Identify a realistic profit target.
- Calculate the planned risk-to-reward ratio.
- Calculate position size based on the amount you can afford to risk.
- Skip the trade if its conditions do not meet your predefined rules.
Do not move a stop-loss farther away simply to make a trade appear less risky on paper.
5. Common Mistakes
Choosing unrealistic targets: A large target is not useful if the market is unlikely to reach it under the strategy's conditions.
Ignoring costs: A narrow target can be materially affected by spreads and commissions.
Confusing ratio with probability: A 1:3 ratio does not mean that a trade has a higher chance of winning.
Changing rules during a trade: Emotional decisions can make historical testing results unreliable.
Conclusion
Risk-to-reward ratio is a useful way to plan trades and evaluate a strategy. However, it should be considered alongside win rate, average realised win and loss, trading costs, drawdown and sufficient historical testing.
A sensible trading plan defines risk before entry instead of relying on hoped-for profits.
Related resources: Risk-to-Reward Calculator, Learning Center.
