Risk-reward ratio

What the risk-reward ratio means

The risk-reward ratio compares two distances on a trade plan: how far price must move against you before you exit with a loss, and how far it must move in your favour before you exit with a gain. It is written as risk to reward. A 1:2 ratio means you plan to risk one unit to try to make two. A 1:0.5 ratio means you plan to risk two units for every one you hope to earn.

The risk side is measured from your entry to your stop-loss. The reward side is measured from your entry to your target, often a take-profit order. Both are measured before the trade is placed, which is why the ratio is a planning tool rather than a result. Once the trade is closed, what you actually made or lost may differ from the plan.

Traders, fund managers and investors all use the idea, though the vocabulary changes. A day trader might talk in pips or points, a share investor in percent, and a risk manager in currency amounts. The underlying logic is the same: before taking exposure, check that the possible payoff is worth the possible cost.

How it works

The ratio is a simple division. Take the distance from entry to target and divide it by the distance from entry to stop.

• Risk = |entry price - stop-loss price|
• Reward = |target price - entry price|
• Reward-to-risk multiple = reward ÷ risk

If you quote it the traditional way, 1:2 corresponds to a reward-to-risk multiple of 2.

The ratio is only half of the picture. The other half is how often the trade works, usually called the win rate. These two combine into the break-even condition: the win rate you need equals 1 ÷ (1 + reward-to-risk multiple), ignoring costs.

• At a 1:1 ratio you need to win more than 50 percent of trades to break even.
• At 1:2 you need to win more than about 33 percent.
• At 1:3 you need to win more than 25 percent.
• At 2:1 (risking two to make one) you need to win more than about 67 percent.

Costs push those thresholds higher. The spread, commission and any swap or overnight financing add to the risk side and subtract from the reward side, so a target that looks like 1:2 on paper can be closer to 1:1.7 after costs.

A worked example

These numbers are illustrative only. A trader plans a long position in a share trading at 80.00 and sets the following levels.

1. Entry: 80.00.
2. Stop-loss: 77.00, which is 3.00 below entry.
3. Target: 86.00, which is 6.00 above entry.
4. Risk = 80.00 - 77.00 = 3.00 per share. Reward = 86.00 - 80.00 = 6.00 per share.
5. Ratio = 3.00 : 6.00, which simplifies to 1:2.

Now apply position sizing. The trader accepts a maximum loss of 150 on this trade.

1. Shares = 150 ÷ 3.00 = 50 shares.
2. If the target is reached, profit = 50 × 6.00 = 300.
3. If the stop is hit, loss = 50 × 3.00 = 150 (plus costs).

Add costs: suppose total round-trip commission and spread cost 0.40 per share. The effective risk becomes 3.40 and the effective reward 5.60. The real ratio is 3.40 : 5.60, about 1:1.65. The break-even win rate is 1 ÷ (1 + 1.65) = roughly 38 percent, not 33.

Why it matters

A ratio does not make a trade good. It tells you what must be true for a series of trades to work. Many beginners focus on being right as often as possible and ignore how large the average win is relative to the average loss. A strategy that wins 70 percent of the time with tiny gains and occasional large losses can still lose money.

The ratio links directly to drawdown. If each loss costs one unit and each win earns two, a run of losses is easier to recover from than if the payoff were one-to-one. It also disciplines decisions: if the nearest sensible stop is far away and the nearest realistic target is close, the ratio exposes a poor setup before money is committed.

Across brokers, costs vary. A wide spread or high commission eats into reward, particularly for short-range targets. Scalpers with tight targets feel this most, because a spread of one pip is a large share of a ten-pip target.

How to use it in practice

1. Place the stop first at a level that invalidates your idea, not at a distance chosen to produce a nice ratio.
2. Set the target at a level the market could plausibly reach, such as the next support or resistance zone.
3. Calculate the ratio including spread and commission.
4. Estimate the win rate you can honestly expect from your own records and compare it with the break-even rate.
5. Size the position from the distance to the stop and your maximum acceptable loss, not from a desired profit.
6. Record planned versus actual ratio in a trade journal, and review how often exits matched the plan.
7. Skip trades where the ratio is clearly unfavourable relative to your tested win rate.

Common mistakes and misconceptions

• Chasing a high ratio. Moving a target far away to show 1:5 usually cuts the chance of it being reached; the win rate falls as the target moves out.
• Moving the stop to improve the ratio. Tightening the stop to fit a target often gets you stopped out by ordinary noise.
• Ignoring costs. Spread, commission and financing change the real ratio, especially on short-term trades.
• Treating the ratio as a forecast. It describes your plan, not what the market will do.
• Forgetting partial exits. If you scale out or trail a stop, the realised ratio will differ from the initial one.
• Confusing ratio with risk per trade. A 1:3 ratio on a position that risks half your account is still reckless.

Risks and limitations

A good ratio does not remove risk. Stops are not guaranteed in fast markets: gaps and slippage can fill a stop beyond its level, making the actual loss larger than planned. Leveraged products can magnify the effect of an adverse move. The ratio also ignores probability, so it can give false comfort when the target is unlikely to be hit. Backtested win rates may not hold in live conditions, and a sample of a few trades says little.

How Brokeli looks at it

We do not suggest entries, stops or targets. What we do review is the cost side that determines your real ratio: typical spreads, commissions, overnight financing and how stop and limit orders are handled. Those inputs come from the published research snapshot for each broker, so you can test your own planned ratio against realistic costs.