Risk reward ratio
Family III · Risk
Not to be confused with forex risk, correlation risk, gap risk.
Risk-reward ratio is a planning measure that relates the distance from an entry price to a protective stop to the distance from that entry to a profit target. It is calculated before a position is opened and does not depend on the probability of the trade succeeding. A ratio of 1:2 means the targeted gain is twice the amount that would be lost if the stop is triggered.
Calculation and interpretation
The ratio is derived from three prices: entry, stop-loss and target. The risk per unit is the absolute difference between entry and stop; the reward per unit is the absolute difference between entry and target. The ratio is usually written with the risk normalised to 1, so a risk of 50 points and a reward of 100 points gives 1:2.
Ratios below 1:1 indicate that the potential loss exceeds the potential gain. Ratios above 1:1 indicate the opposite. The ratio says nothing about whether the target will be reached; it only describes the terms of the trade if both levels are respected.
Worked example
Use and limitations
Traders use the ratio to compare potential trades and to set minimum standards for entry. A common approach is to require a ratio of at least 1:2, but the appropriate threshold varies by strategy, market and timeframe. The ratio is not a forecast of profitability: a high ratio with a low probability of success can still produce net losses, and a low ratio with a high probability can be profitable.
The ratio also assumes that the stop and target are actually executed at the specified prices. Slippage, gaps and illiquidity can alter the realised risk and reward, so the planned ratio may differ from the outcome.
Often confused with
- forex risk
- Forex risk refers to the general exposure to loss in currency markets, including leverage and volatility, whereas risk-reward ratio is a specific comparison of two price distances; the visible sign is that forex risk is a broad category, while risk-reward ratio is a number such as 1:2.
- correlation risk
- Correlation risk is the danger that positions move together and concentrate exposure, while risk-reward ratio measures the terms of a single trade; the visible sign is that correlation risk involves multiple positions, whereas risk-reward ratio involves one entry, one stop and one target.
- gap risk
- Gap risk is the possibility that price jumps between bars or sessions so that a stop executes at a worse level than planned, while risk-reward ratio is calculated from intended levels; the visible sign is that gap risk describes an execution shortfall, whereas risk-reward ratio is a pre-trade planning figure.