Risk-Reward Ratio
Quick Definition
The ratio comparing the potential loss (risk) to the potential gain (reward) of a trade or investment, expressed as risk:reward.
What Is Risk-Reward Ratio?
The risk-reward ratio compares how much you stand to lose versus how much you could gain on a trade. It's a fundamental tool for determining whether a trade is worth taking.
How It Works:
- Risk = Entry Price - Stop Loss Price
- Reward = Target Price - Entry Price
- Ratio = Risk / Reward
Common Risk-Reward Ratios:
| Ratio | Meaning | Required Win Rate |
|---|---|---|
| 1:1 | Risk $1 to make $1 | >50% to profit |
| 1:2 | Risk $1 to make $2 | >33% to profit |
| 1:3 | Risk $1 to make $3 | >25% to profit |
| 1:5 | Risk $1 to make $5 | >17% to profit |
Example Trade:
- Buy stock at $50
- Stop loss at $47 (risk = $3)
- Target at $59 (reward = $9)
- Risk-Reward = 1:3
Why It Matters: Even with a 40% win rate, a 1:3 risk-reward ratio is profitable:
- 10 trades: 4 winners × $9 = $36, 6 losers × $3 = $18
- Net profit: $18 on 10 trades
Professional Minimum: Most professional traders won't take a trade with less than 1:2 risk-reward. Many aim for 1:3 or better.
Application to Investing:
- Value investors: Buy at significant discount to intrinsic value (built-in risk-reward)
- Growth investors: Upside potential should be 3x+ the downside risk
- Portfolio level: Expected return should adequately compensate for portfolio volatility
Formula
Formula
R:R = (Entry - Stop Loss) / (Target - Entry)Risk-Reward Ratio Example
- 1A trader buys at $100 with stop-loss at $95 and target at $115: risk-reward is 1:3
- 2Warren Buffett seeks investments where the upside is significantly greater than the downside — inherent risk-reward thinking
Related Terms
Risk Management
The systematic process of identifying, assessing, and mitigating financial risks to protect portfolio value and achieve investment objectives.
Sharpe Ratio
A risk-adjusted return metric measuring excess return per unit of risk, helping compare investments with different risk levels.
Maximum Drawdown
The largest peak-to-trough decline in portfolio value before a new peak is reached, measuring worst-case loss.
Kelly Criterion
A formula for determining the optimal bet size that maximizes long-term growth rate while accounting for both the probability and magnitude of wins and losses.
Standard Deviation
A statistical measure of how spread out returns are from the average, quantifying investment volatility and risk.
Hedging
An investment strategy that uses offsetting positions to reduce the risk of adverse price movements in an existing asset or portfolio.
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