Risk-Reward Ratio Explained: How to Evaluate Any Trade
The risk-reward ratio is one of the simplest and most powerful concepts in trading. It tells you how much you stand to gain for every dollar you risk. Once you understand it, you will never look at a trade the same way again.
What Is the Risk-Reward Ratio?
The risk-reward ratio (often written as R:R) compares the potential loss of a trade to its potential gain. It is calculated by dividing the distance from your entry to your stop-loss by the distance from your entry to your profit target.
Risk-Reward Ratio = (Entry Price - Stop-Loss) / (Target Price - Entry Price)
A ratio of 1:2 means you are risking $1 to make $2. A ratio of 1:3 means you are risking $1 to make $3. The lower the first number relative to the second, the better the trade looks on paper.
How to Calculate It
Example 1: A Breakout Trade
You buy a stock at $50. Your stop-loss is at $48 (risking $2 per share). Your target is $56 (potential gain of $6 per share).
R:R = $2 / $6 = 1:3. For every dollar you risk, you stand to make three. This is a strong setup.
Example 2: A Pullback Entry
You buy at $120. Stop at $115 (risk $5). Target at $130 (reward $10).
R:R = $5 / $10 = 1:2. You need to be right on only about one-third of these trades to break even. More on that below.
Example 3: A Poor Setup
You buy at $75. Stop at $70 (risk $5). Target at $78 (reward $3).
R:R = $5 / $3 = 1:0.6. You are risking more than you stand to gain. You would need to win nearly two-thirds of the time just to break even. Most traders should skip this trade.
Use the Risk-Reward Calculator to quickly evaluate any setup.
The Break-Even Win Rate Table
This is the most important table in trading. It shows the minimum win rate you need to break even at each risk-reward ratio:
| Risk:Reward | Break-Even Win Rate | Interpretation |
|---|---|---|
| 1:0.5 | 67% | Need to win 2 out of 3 trades |
| 1:1 | 50% | Need to win half your trades |
| 1:1.5 | 40% | Can lose 3 out of 5 trades |
| 1:2 | 33% | Can lose 2 out of 3 trades |
| 1:3 | 25% | Can lose 3 out of 4 trades |
| 1:4 | 20% | Can lose 4 out of 5 trades |
| 1:5 | 17% | Can lose 5 out of 6 trades |
The formula behind this table is: Break-Even Win Rate = 1 / (1 + Reward/Risk). At a 1:2 ratio, that is 1 / (1 + 2) = 33%.
Why Most Traders Fail: Bad Risk-Reward
Many traders have a decent win rate but still lose money. The reason is almost always a bad risk-reward ratio. They take small profits quickly but let losses run. They might win 60% of their trades but still end up negative because their average loss is three times their average win.
Consider two traders:
- Trader A: Wins 70% of trades. Average win: $200. Average loss: $600. Result after 100 trades: (70 x $200) - (30 x $600) = $14,000 - $18,000 = -$4,000.
- Trader B: Wins 40% of trades. Average win: $600. Average loss: $200. Result after 100 trades: (40 x $600) - (60 x $200) = $24,000 - $12,000 = +$12,000.
Trader B wins less often but makes far more money. The difference is risk-reward discipline.
What Makes a Good Ratio?
As a general rule, avoid any trade with a risk-reward ratio worse than 1:1.5. A minimum of 1:2 is a solid standard for swing traders. Day traders working with high win-rate setups can sometimes accept 1:1, but they need a consistently high win rate to make it work.
The best setups combine a high-probability pattern (like a bull flag) with a favorable risk-reward ratio. When the chart pattern gives you a tight stop and a clear target, the math works in your favor.
How to Improve Your Risk-Reward Ratio
- Wait for better entries. Buying on a pullback to support rather than chasing a breakout gives you a tighter stop and a bigger reward.
- Use chart patterns to define targets. Measured moves from bull flags, cup-and-handle patterns, and other setups give you realistic profit targets.
- Place stops at logical levels. A stop placed just below a support level is more meaningful than an arbitrary percentage stop. Logical stops can be tighter, improving your ratio.
- Skip low-ratio setups. If the math does not work before you enter, it will not work after. Discipline means passing on trades that do not meet your minimum ratio.
- Use multiple targets. Take partial profits at the first target and let the rest run. This locks in gains while keeping upside open.
Putting It All Together
Before every trade, calculate your risk-reward ratio. Check it against the break-even table. If you need a 60% win rate to break even and your historical win rate is 45%, the trade is not worth taking. Combine this analysis with proper position sizing and you have a complete risk management framework.
Use the Risk-Reward Calculator and Profit/Loss Calculator to evaluate your next trade.