Risk-Reward Ratio Explained

What Is the Risk-Reward Ratio?

The risk-reward ratio compares how much you stand to lose on a trade if it goes wrong against how much you stand to gain if it goes right. It’s usually expressed as a ratio like 1:2 or 1:3, meaning you’re risking one unit to potentially gain two or three units.

This single number is one of the most useful planning tools in trading because it forces you to define both your stop-loss and your take-profit before you open a trade, rather than deciding exits emotionally once the position is live.

How to Calculate the Risk-Reward Ratio

Risk-Reward Ratio = Distance to Take-Profit ÷ Distance to Stop-Loss

Worked example:

• You go long EUR/USD at 1.0850.
• Your stop-loss is at 1.0830 (20 pips of risk).
• Your take-profit is at 1.0890 (40 pips of potential reward).
• Risk-reward ratio = 40 ÷ 20 = 1:2

This means that if the trade wins, the gain is twice the size of the loss you’d take if the trade lost. This calculation is independent of position size — whether you trade 0.1 lots or 5 lots, the ratio stays 1:2 as long as the pip distances remain the same.

Why Risk-Reward Ratio Alone Isn’t Enough

A favorable risk-reward ratio is only half of the profitability equation. The other half is your win rate — the percentage of trades that hit your take-profit rather than your stop-loss. The two must be considered together.

The Expectancy Formula

Expectancy = (Win rate × Average win) − (Loss rate × Average loss)

If expectancy is positive, the strategy is profitable over a large enough sample of trades, before accounting for costs like spread, commission and swap.

Worked Example: Comparing Two Strategies

Strategy A: High win rate, low risk-reward

• Win rate: 70%
• Risk-reward ratio: 1:1 (risk $50 to make $50)
• Expectancy per trade = (0.70 × $50) − (0.30 × $50) = $35 − $15 = +$20

Strategy B: Lower win rate, higher risk-reward

• Win rate: 40%
• Risk-reward ratio: 1:2.5 (risk $50 to make $125)
• Expectancy per trade = (0.40 × $125) − (0.60 × $50) = $50 − $30 = +$20

Both strategies have identical expectancy despite very different win rates. This illustrates why a trader with a lower win rate isn’t necessarily worse off — it depends entirely on how those two numbers combine. It also shows why judging a strategy purely by how often it “wins” is misleading without knowing the risk-reward ratio behind those wins and losses.

Worked Example: When a High Risk-Reward Ratio Fails

Strategy C: Very high risk-reward, but rarely hit

• Win rate: 20%
• Risk-reward ratio: 1:3 (risk $50 to make $150)
• Expectancy per trade = (0.20 × $150) − (0.80 × $50) = $30 − $40 = −$10

Even a seemingly attractive 1:3 ratio produces a losing strategy if the win rate is too low to support it. This is why a risk-reward target should be realistic for the strategy and market conditions actually being traded, not chosen simply because a bigger number looks better on paper.

Finding Your Break-Even Win Rate

For any risk-reward ratio, there’s a minimum win rate required just to break even (before costs):

Break-even win rate = 1 ÷ (1 + Risk-Reward Ratio)

• At 1:1, break-even win rate = 1 ÷ (1+1) = 50%
• At 1:2, break-even win rate = 1 ÷ (1+2) = 33.3%
• At 1:3, break-even win rate = 1 ÷ (1+3) = 25%

This is useful for evaluating your own trading results: if your actual win rate at a given risk-reward ratio is consistently above the break-even threshold, the strategy has positive expectancy, at least before trading costs are applied.

How Risk-Reward Interacts With Position Sizing

The risk-reward ratio tells you the shape of a trade — how the potential gain compares to the potential loss — but it doesn’t tell you the size of that loss in dollar terms. That’s determined separately through position sizing, based on your account balance and risk-per-trade percentage. A 1:2 risk-reward trade can risk $50 or $500 depending entirely on how many lots are traded; the ratio itself stays the same either way.

Practical Ways to Use Risk-Reward Ratio

• Set both levels before entering. Decide your stop-loss and take-profit as part of your trade plan, not after watching the position move.
• Use market structure, not arbitrary ratios, to set targets. A take-profit should generally be placed near a realistic level such as a prior resistance or support zone, with the resulting ratio calculated afterward — not the reverse.
• Track your actual results. Keep a trading journal recording the risk-reward ratio and outcome of every trade to calculate your real win rate and expectancy over time.
• Factor in trading costs. Spreads and commissions effectively increase the risk side of the ratio slightly on every trade, particularly for short-term strategies with tight stops — see understanding trading costs.

Key Takeaways

• The risk-reward ratio compares potential loss to potential gain on a trade, calculated as reward distance ÷ risk distance.
• A favorable ratio (such as 1:2) allows a strategy to be profitable even with a win rate below 50%.
• Risk-reward ratio and win rate must be evaluated together using expectancy — neither number alone tells you whether a strategy works.
• Every risk-reward ratio has a break-even win rate; results consistently above that threshold indicate positive expectancy before costs.
• Risk-reward ratio defines the shape of a trade; position sizing defines its dollar size — both are needed for a complete risk plan.

Risk note: Risk-reward ratios and expectancy calculations are planning tools, not guarantees. Real trading involves spreads, commissions, swap costs and slippage, all of which can reduce actual returns below the theoretical numbers shown here. Trading forex and CFDs carries a high level of risk and may not be suitable for everyone.