HFM information and reviews
HFM
96%
FXCC information and reviews
FXCC
92%
FxPro information and reviews
FxPro
89%
FBS information and reviews
FBS
88%
Vantage information and reviews
Vantage
85%
XM information and reviews
XM
82%

What Is the Risk/Reward Ratio and How to Use It


The risk/reward ratio tells you how much risk you are taking for how much potential reward. Good traders and investors choose their bets very carefully. They look for the highest potential upside with the lowest potential downside. If an investment can bring the same yield as another, but with less risk, it may be a better bet. Whether you’re day trading or swing trading, there are a few fundamental concepts about risk that you should understand.

These form the basis of your understanding of the market and give you a foundation to guide your trading activities and investment decisions. Otherwise, you won’t be able to protect and grow your trading account.

Interested to learn how to calculate this for yourself? Let’s read on.

What is the risk/reward ratio?

The risk/reward ratio marks the prospective reward an investor can earn for every dollar they risk on an investment. Many investors use risk/reward ratios to compare the expected returns of an investment with the amount of risk they must undertake to earn these returns. Consider the following example: an investment with a risk-reward ratio of 1:7 suggests that an investor is willing to risk $1, for the prospect of earning $7. Alternatively, a risk/reward ratio of 1:3 signals that an investor should expect to invest $1, for the prospect of earning $3 on their investment.

The calculation itself is very simple. You divide your maximum risk by your net target profit. How do you do that? First, you look at where you would want to enter the trade. Then, you decide where you would take profits (if the trade is successful), and where you would put your stop-loss (if it’s a losing trade). This is crucial if you want to manage your risk properly. Good traders set their profit targets and stop-loss before entering a trade.

Now you’ve got both your entry and exit targets, which means you can calculate your risk/reward ratio. You do that by dividing your potential risk by your potential reward. The lower the ratio is, the more potential reward you’re getting per “unit” of risk. Let’s see how it works in practice. It’s worth noting that many traders do this calculation in reverse, calculating the reward/risk ratio instead. Why? Well, it’s just a matter of preference. Some find this easier to understand. The calculation is just the opposite of the risk/reward ratio formula. As such, our reward/risk ratio in the example above would be 15/5 = 3. As you’d expect, a high reward/risk ratio is better than a low reward/risk ratio.

Limitations of the Risk/Reward Ratio

A low risk/reward ratio does not tell you everything you need to know about a trade. You also need to know the likelihood of reaching those targets. A common mistake for day traders is having a certain R/R ratio in mind before analyzing a trade. This can lead traders to establish their stop-loss and profit targets based on the entry point, rather than the value of the security, without taking into account the market conditions surrounding that trade.

Choosing the best risk/reward ratios is a balancing act between taking trades that offer more profit than risk while ensuring the trade still has a reasonable chance of reaching the target before the stop loss.

What Is the Risk/Reward Ratio and How to Use It

What Does the Risk/Reward Ratio Tell You?

The risk/reward ratio helps investors manage their risk of losing money on trades. Even if a trader has some profitable trades, they will lose money over time if their win rate is below 50%. The risk/reward ratio measures the difference between a trade entry point to a stop-loss and a sell or take-profit order. Comparing these two provides the ratio of profit to loss, or reward to risk.

Investors often use stop-loss orders when trading individual stocks to help minimize losses and directly manage their investments with a risk/reward focus. A stop-loss order is a trading trigger placed on a stock that automates the selling of the stock from a portfolio if the stock reaches a specified low. Investors can automatically set stop-loss orders through brokerage accounts and typically do not require exorbitant additional trading costs.

Conclusion

We’ve looked at what the risk/reward ratio is and how traders can incorporate it into their trading plan. Calculating the risk/reward ratio is essential when it comes to the risk profile of any money management strategy. What’s also worth considering when it comes to risk is keeping a trading journal. By documenting your trades, you can get a more accurate picture of the performance of your strategies. In addition, you can potentially adapt them to different market environments and asset classes.

#source


RELATED

What Is a Bear Trap in Trading and How to Handle It?

You may have heard of a bull trap, but if you haven't, we recently covered this topic in an article. In this guide, we'd like to tell you about the opposite event in the market: a bear trap...

A Comprehensive Guide to Technical Analysis: Definition, Tools & Examples

Technical Analysis is a systematized approach employed by traders to predict price movements and trends by examining market data, primarily price and volume...

What is technical analysis?

Technical analysis in one of the most widely used methods of forecasting price movements. The basis behind this type of analysis is the supposition that on the market...

Beautiful Signals of the Butterfly Pattern

The butterfly pattern. It sounds nice, doesn't it? However, the real hides many difficulties for traders, especially for newbies. It's not a common trading tool...

Technical Analysis: Directional Movement Index

Get ready for another instalment in our technical analysis educational series. After a multi-week hiatus, we’re back and ready to share even more knowledge

Bullish and Bearish Divergence: How to Catch a Signal

In analytics, there is a chance you’ll come across the term divergence. Divergence is one of the well-known market conditions that provide reliable signals...

Price Gaps In Forex Trading: Types, Causes, And Strategies

Price gaps are a common phenomenon in forex trading, characterized by a significant difference between the closing and opening prices of an asset...

Sentiment analysis for Forex traders

There are many ways to level up your Forex skills, but defining the trends is a necessity if you want to place successful orders. So, how do you identify a trend...

Elliott Waves for Forex Market Analysis

Studying the Forex market, it is easy to notice that the price movement on it occurs in waves. For decades many traders have been trying to find...

Awesome Oscillator: Strategies & Uses

The awesome oscillator is a market momentum indicator that is used to define reversals and corrections of the price. It's one of the easiest but most effective trading tools...

ADX: Find the Strong Trend

In a wide variety of indicators that provide different signals, it's almost impossible to find the one that defines the trend's strength. It's vital to know whether the trend is stable or not, especially during...

A Pullback: Trade Against a Trend

Reading analytical outlooks on the price movements, you might be met with the word “pullback”. Many trading strategies are based on a pullback action...

Types of analysis when trading in financial markets

It is well known that trading in the financial markets is one of the most dynamic and effective ways to make a profit, even in the absence of significant initial capital...

Read the markets: Technical & Fundamental analysis

One of the biggest concepts in trading relates to Market Analysis and how to read the markets. This includes both Fundamental analysis and Technical analysis...

Three technical indicators you should know about

Seeing a list of indicators, you might easily get lost. This article will help you learn about 3 essential indicators that will help you define your trading strategy for any time period...

What Are Order Blocks In Forex? Unraveling the Impact of Big Market Players

In the vast and intricate world of Forex trading, the presence of order blocks plays a crucial role in shaping market dynamics. Introduced by large financial institutions and central banks...

T4Trade: Technical Analysis Techniques

Technical analysis techniques are vital for making informed trading decisions and to reduce the risk of large capital losses. In this article, we explore some of the most popular techniques and tools used by traders worldwide...

XPro Markets - Boost your Technical Analysis Skills

What is your angle when trading in the financial markets? Do you opt for the technical analysis strategy or are you a "fundamentalist" when it comes to trading?

Japanese Candlestick Chart Analysis

The most convenient option for charting any asset on Forex is Japanese candles. The information content and the state of the market's data...

Basics of Options Trading: Understanding Put vs Call Option

A popular tool for speculation is options trading, where money can move fast, and traders can gain (or lose) their stakes quickly. But what are options contracts...

FP Markets information and reviews
FP Markets
81%
IronFX information and reviews
IronFX
77%
T4Trade information and reviews
T4Trade
76%
Exness information and reviews
Exness
76%
Just2Trade information and reviews
Just2Trade
76%
FXNovus information and reviews
FXNovus
75%

© 2006-2025 Forex-Ratings.com

The usage of this website constitutes acceptance of the following legal information.
Any contracts of financial instruments offered to conclude bear high risks and may result in the full loss of the deposited funds. Prior to making transactions one should get acquainted with the risks to which they relate. All the information featured on the website (reviews, brokers' news, comments, analysis, quotes, forecasts or other information materials provided by Forex Ratings, as well as information provided by the partners), including graphical information about the forex companies, brokers and dealing desks, is intended solely for informational purposes, is not a means of advertising them, and doesn't imply direct instructions for investing. Forex Ratings shall not be liable for any loss, including unlimited loss of funds, which may arise directly or indirectly from the usage of this information. The editorial staff of the website does not bear any responsibility whatsoever for the content of the comments or reviews made by the site users about the forex companies. The entire responsibility for the contents rests with the commentators. Reprint of the materials is available only with the permission of the editorial staff.
We use cookies to improve your experience and to make your stay with us more comfortable. By using Forex-Ratings.com website you agree to the cookies policy.