The risk-reward ratio compares how much a trader is willing to risk on a trade versus the potential profit. For example, risking 100 USD to target 300 USD represents a 1:3 risk-reward ratio. This ratio is essential because it helps traders evaluate trades objectively rather than making impulsive decisions based on emotion.
Traders often pair the risk-reward ratio with their win rate to determine if a trading strategy is likely to be profitable over time. For instance, a trade with a 1:3 risk-reward ratio only needs to succeed one out of three times to break even. Understanding this helps you structure trades that align with your overall strategy and capital management plan.
How to Calculate It
- Determine your stop-loss: Identify the price level where the trade becomes invalid.
- Set your take-profit: Decide the level at which you will exit to secure gains.
- Calculate the ratio: Divide potential profit by potential loss.
For example, if your stop-loss is 50 USD below your entry and your take-profit is 150 USD above, your risk-reward ratio is 1:3. Consistently applying this method ensures each trade has a defined risk and potential reward, improving discipline and consistency.