Trading
Risk-Reward Ratio
The ratio of potential loss to potential gain on a trade, based on planned stop-loss and profit-target prices.
Formula
Risk-Reward = Amount at Risk : Potential Reward
Variables
Amount at Risk- Difference between entry and stop-loss price
Potential Reward- Difference between entry and profit target price
Worked Example
Scenario: Buy at $50, stop-loss at $46, target $58: risk $4, reward $8, ratio is 1:2.
Steps:
- Calculate loss: entry − stop = $50 − $46 = $4
- Calculate reward: target − entry = $58 − $50 = $8
- Express as ratio: 1:2 (risk to reward)
When to Use This Formula
- Plan trade entry, stop-loss, and target
- Evaluate risk-adjusted profitability
- Ensure favorable probability-adjusted outcomes
Limitations & Assumptions
- Stops may fill worse than planned
- Targets may not be reached
- Does not account for probability (1:3 ratio still requires high win rate)
Common Questions
Is a 1:3 ratio good?
It depends on win rate. A 1:3 ratio requires 25%+ win rate to break even; with 50% win rate, you profit significantly.
Measuring return and risk
- Beta formulaFormula
- Alpha formulaFormula
- Sharpe ratioDefinition
- Sortino ratioDefinition
- Maximum drawdownDefinition
Reference note: This is an educational mathematical reference. The formula's applicability depends on assumptions, market conditions, and use case. Always verify results independently and consult domain experts for decisions.