Risk Reward Ratio: Definition, Formula, Examples, How It Improve Your Trading
If you trade or invest, you will see people talk about “good risk reward” all the time. The risk reward ratio is a simple way to compare how much you could lose on a trade versus how much you could make if it works.
Used well, it helps you avoid bad setups, stay disciplined, and think in terms of probabilities instead of emotions.
Risk Reward Ratio Meaning
The risk reward ratio compares:
- Risk: how much you are willing to lose if the trade goes wrong
- Reward: how much you expect to gain if the trade hits your target
Most traders write it as risk:reward.
- Risk 100 dollars to make 200 dollars is written as 1:2
- Risk 100 dollars to make 300 dollars is 1:3
The lower the first number relative to the second, the more attractive the setup looks.
Some people flip it and say “reward to risk” instead.
What matters is that you are consistent and know which side is which.
How To Calculate Risk Reward Ratio
1. Define your risk per trade
Start by choosing your stop loss level.
This is the price where you will exit if the trade is wrong.
Risk per share equals:
Entry price minus stop loss (for a long trade)
Total dollar risk is:
Risk per share multiplied by number of shares
2. Define your potential reward
Next, choose your target price. This is where you plan to take profits if the trade goes well.
Reward per share equals:
Target price minus entry price
Total potential reward is:
Reward per share multiplied by number of shares
3. Apply the risk reward formula
The basic formula is:
Risk Reward Ratio = Potential Loss ÷ Potential Profit
Example:
- You buy a stock at 50 dollars
- Stop loss is 47 dollars (risk 3 dollars per share)
- Target is 56 dollars (reward 6 dollars per share)
Risk reward ratio:
3 ÷ 6 = 0.5
Written as 1:2, because you risk 1 unit for every 2 units of potential gain.
Why Risk Reward Ratio Matters
The risk reward ratio does not tell you if a trade will win.
It tells you how balanced the trade is if you stick to your plan.
It helps you:
- Avoid trades where the downside is large and the upside is small
- Focus on setups that can move enough to justify the risk
- Build a strategy that still works even if you do not win every time
For example, if you usually risk 1 dollar to make 3 dollars (1:3), you can be wrong more often and still be profitable, as long as you respect your stops.
Common Risk Reward Guidelines
Many traders use simple rules such as:
- Minimum 1:2 risk reward for any trade
- Aim for 1:3 or better for higher quality setups
These are not laws. They are guidelines that help you avoid chasing tiny gains with big downside.
Long term investors can think in similar terms.
If a stock has limited upside based on fundamentals but heavy downside if things go wrong, the risk reward is poor, even if the business looks good today.
Limitations Of Risk Reward Ratio
The risk reward ratio is useful, but it is not enough on its own.
It ignores win rate
A high risk reward ratio means nothing if your win rate is very low.
A strategy that wins rarely but targets big gains can still lose money overall.
It assumes you follow your plan
Risk reward calculations assume you honour your stop loss and your target.
If you constantly move stops or take profits early, the real ratio is very different from your plan.
It does not predict market conditions
The ratio is based on your chosen levels, not on what the market will actually do.
Volatility, gaps and news can all cause actual results to differ from your neat numbers.
How Retail Investors Can Use Risk Reward
1. Filter trades
Use risk reward as a basic filter.
If a setup is worse than 1:1, consider skipping it unless you have a strong reason.
2. Align with your risk per trade
Combine risk reward with a fixed risk per trade rule. For example, never risk more than 1 or 2 percent of your account on any single idea.
3. Compare different ideas
If you have several possible trades, compare their risk reward ratios. This helps you choose the ones where the potential payoff better matches the risk.
4. Apply it to long term investing
Even if you invest for years, you can still think in risk reward terms. Consider:
- How much the stock could reasonably fall in a bad scenario
- How much upside you see based on earnings and valuation
This frames decisions in probabilities, not stories.
Conclusion
The risk reward ratio is a simple tool that compares how much you could lose on a position to how much you could gain if it works out.
Used with realistic stops, targets and position sizing, it helps you say no to trades where the downside is not worth it, and focus your capital on better balanced ideas.
It does not replace a full strategy, but it adds discipline and structure to the way you think about risk.
If you want to practice building better risk reward habits with real US stocks and ETFs, apps like Gotrade let you start small with fractional shares, so you can size trades more precisely and keep your risk under control from day one.
FAQ
- What is a good risk reward ratio for trading?
Many traders aim for at least 1:2, meaning they risk 1 dollar to make 2 dollars. Some target 1:3 or better for high quality setups. - Is a higher risk reward ratio always better?
Not always. A very high ratio is useless if your win rate is extremely low or your targets are unrealistic. Both win rate and risk reward matter. - Do long term investors need risk reward ratios?
Yes. Even long term investors should think about downside versus upside, so they avoid situations where potential losses far outweigh potential gains.
Reference:
Disclaimer
Gotrade is the trading name of Gotrade Securities Inc., which is registered with and supervised by the Labuan Financial Services Authority (LFSA). This content is for educational purposes only and does not constitute financial advice. Always do your own research (DYOR) before investing.
