What is the Risk/Reward Ratio?

Key Takeaways

● The risk/reward ratio is a measure that compares the potential profit of trade with its potential loss.

● Calculating the risk/reward ratio involves dividing the difference between the trade's entry point and the stop-loss order (the risk) by the difference between the trade's entry point and the profit target (the reward).

● The risk/reward ratio should be used along with other risk-management ratios to measure whether a trade is a good risk or not.

Understanding the Risk/Reward Ratio

The risk/reward ratio also referred to as the R/R ratio, is a measure that compares the potential profit (the reward) of trade to its potential loss (the risk).

Risk/Reward ratio = (Entry point - Stop loss point)/(Profit target - Entry point)

To calculate the risk/reward ratio, start by figuring out both the risk and the reward.

Risk is the total potential loss that a stop-loss order determines. It's the difference between the trade's entry point and the stop-loss order.

Reward is the total potential profit, established by a profit target which is the point at which the security is sold.

What Does the Risk/Reward Ratio Tell You?

The risk/reward ratio helps investors manage their risk of losing money on trades. It is the relationship between these two numbers: the risk divided by the reward. If the ratio is greater than 1.0, the potential risk is greater than the potential reward of the trade. If the ratio is less than 1.0, the potential profit is greater than the potential loss.

Limitations of the Risk/Reward Ratio

A low risk/reward ratio does not tell you everything you need to know about trade. It is frequently utilized along with other risk-management metrics like the win/loss ratio and break-even. You should also include multiple indicators and technical analyses to make strong, data-driven decisions.