What is the Risk-Reward Ratio? A Simple Guide

Quick Answer

The risk-reward ratio compares how much you stand to lose on a trade with how much you stand to gain. A ratio of 1:2 means you risk one rupee to potentially make two. Focusing on trades with favourable ratios means you can be right less than half the time and still make money, which is why it is central to disciplined trading.

Many traders judge themselves purely on how often they are right, but that misses half the picture. What matters just as much is how much you make when you win compared with how much you lose when you are wrong.

The risk-reward ratio captures exactly this. It reframes trading around the balance between potential loss and potential gain, and it explains why some traders profit despite losing more often than they win.

This guide explains what the risk-reward ratio is, how to calculate it, and how it combines with your win rate to determine whether you make money.

Key Takeaways

• The risk-reward ratio compares potential loss to potential gain.
• A 1:2 ratio risks one to make two.
• Favourable ratios let you profit while winning less often.
• It is set by your entry, target and stop loss.
• It works together with your win rate.

What is the risk-reward ratio?

The risk-reward ratio measures how much you are risking on a trade against how much you aim to gain. The risk is the distance from your entry to your stop loss; the reward is the distance from your entry to your target. Expressed as a ratio like 1:2, it tells you at a glance whether the potential gain justifies the potential loss.

How do you calculate it?

Take the difference between your entry price and your stop loss as the risk, and the difference between your entry price and your target as the reward, then compare them.

Risk-Reward Ratio = (Entry − Stop Loss) : (Target − Entry)

For example, you buy a stock at one hundred rupees, set a stop loss at ninety-five rupees, and a target at one hundred ten rupees. Your risk is five rupees and your reward is ten rupees, giving a risk-reward ratio of 1:2. You are risking five rupees to make ten.

Why does it matter?

A favourable risk-reward ratio means you can be wrong more often than right and still come out ahead. If each win is worth twice each loss, you only need to win about a third of your trades to break even. This frees you from the impossible pressure of being right most of the time and focuses you instead on the quality of each trade.

Trading and intraday strategies carry a high risk of loss and are not suitable for every investor. This article is educational and is not a recommendation to trade.

Frequently Asked Questions