A risk-reward ratio compares the distance from the entry to the stop with the distance from the entry to the target. A ratio of 1 to 3 means the target is three times as far from the entry as the stop. It describes the shape of a trade, which is useful, but it does not say whether the trade will work. Many traders use the ratio as a first filter before they look at anything else.
This guide shows how to calculate the ratio, explains why a favourable ratio is not enough on its own, and sets out how to test the ratio together with the win rate. The examples use invented prices and illustrative results.
What is a risk-reward ratio?
The risk is the distance from entry to stop, which is the amount you lose per unit if the trade is wrong. The reward is the distance from entry to target, which is the amount you gain per unit if the trade works.
Dividing reward by risk gives the ratio, and the result tells you how much you aim to make for each unit you risk.
The worked example below uses invented prices for a single long trade. The figures are illustrative.
| Item | Price | Distance from entry | What it means |
|---|---|---|---|
| Entry | 50 | 0 | Where the trade starts |
| Stop | 48 | 2 below entry (risk) | Where the trade is wrong |
| Target | 56 | 6 above entry (reward) | Where the trade is planned to close for a gain |
Reward of 6 divided by risk of 2 gives 3, so the ratio is 1 to 3. For every unit risked, the trade aims to gain three. The ratio is set by the chart, the stop and the target, which is why the stop and target should be chosen from the market rather than from a wish for a particular ratio.
Why is a good ratio not enough?
A high ratio can still lose money if the target is rarely reached. The ratio describes what happens when a trade works, but most trades in any method will not all work. The ratio must be combined with the win rate, which is the share of trades that reach their target before their stop.
The average result per trade, often called expectancy, depends on both.
The table below shows the average result per trade for a fixed 1 to 3 ratio at three illustrative win rates. Results are measured in units of risk, so a result of 0.6 means 0.6 units gained for each unit risked, before costs.
| Win rate | Reward per win | Loss per loss | Average result per trade |
|---|---|---|---|
| 40% | +3 | −1 | +0.6 units of risk |
| 25% | +3 | −1 | 0.0 units (break-even before costs) |
| 20% | +3 | −1 | −0.2 units of risk |
At a 40 percent win rate, the trade earns money on average. At 25 percent, the wins exactly balance the losses before costs, and at 20 percent the method loses money despite a 1 to 3 ratio. The ratio did not change in any row. Only the win rate did, and that changed whether the method made money at all. Costs would push each result lower.
How do you set the target?
Set the target from the chart, such as the next resistance level or a measured move, rather than to fit a desired ratio. A target chosen only to make the ratio look good is a guess, and it tells you nothing about whether the price is likely to reach it.
If the chart does not offer a sensible target, the trade may not be worth taking, regardless of the ratio it would have had.
The stop should be placed where the trade is wrong, which is usually beyond a level or a swing point. A stop placed close to the entry to improve the ratio may be hit by normal movement. A stop placed too far away can make a good target look poor. Choose the stop and the target from the market first, and let the ratio follow from them.
How should you test a ratio?
Test the ratio on past trades using the same entry, stop and target rules, and record the outcome of every trade. The test should show the win rate and the average result per trade, not only the ratio written on paper.
Include costs, because they reduce the reward and increase the effective risk, and a method that looks profitable before costs can lose money after them.
A useful test covers several market conditions, not just a favourable period. Note how the results change in trending and sideways markets, since the same ratio can perform very differently in each. If the result depends on a small number of large wins, the method is fragile, and a single poor run can erase its gains.
It is also worth recording the largest losing streak in the test, because that streak is what a trader must survive in practice. A method with an average result above zero can still produce a run of losses long enough to test patience and discipline, and the test should show whether the account could absorb that run.
How do costs change the ratio?
Costs reduce the reward and increase the effective risk, so a trade that looks like 1 to 3 on the chart may be closer to 1 to 2.2 after costs. Commissions, spreads and slippage at the stop all count, and they matter most for small targets.
Consider a trade with a risk of 2 and a target of 6. If the round trip costs 0.5 per unit, the reward falls to 5.5 and the risk rises to 2.5, a ratio of about 2.2 to 1. The difference can be large enough to change whether the method is worth using, so include costs in every calculation.
Slippage at the stop is harder to predict. In fast markets a stop can fill beyond the planned price, which increases the loss. Test the method with realistic fills, not only the prices shown on the chart.
Common mistakes
Choosing the target to hit a ratio. A target should come from the chart. The ratio should be the outcome, not the input.
Judging a method by its ratio alone. A 1 to 3 ratio with a low win rate can lose money. Always look at the win rate as well.
Ignoring costs. Commissions and spreads reduce every result. A method with a thin edge can be unprofitable once they are counted.
Testing without a fixed rule. A ratio that changes from trade to trade cannot be evaluated. Keep the entry, stop and target rules the same across the whole test.
Checklist
- Set the entry, the stop and the target from the chart, in that order.
- Calculate the risk as the distance from entry to stop, and the reward as the distance from entry to target.
- Divide the reward by the risk to get the ratio.
- Record the win rate for the method, using past trades that follow the same rules.
- Work out the average result per trade, including costs.
- Test the method across different market conditions.
- Check whether the result depends on a few large wins, and treat that as a warning if it does.
Key takeaways
A risk-reward ratio compares the distance to the target with the distance to the stop. It describes the shape of a trade but not whether the trade will work. The average result per trade depends on both the ratio and the win rate, and costs reduce both. Choose the stop and target from the chart, and test the ratio together with the win rate before relying on it.
This guide is for general information, not financial advice. See the disclaimer.