Risk-Reward Ratio: Comparing Possible Loss With Possible Gain Before Entering a Trade

The risk-reward ratio compares the potential loss on a trade or investment with the potential gain.

It is a planning tool, not a prediction tool. Its job is to help the investor think clearly about downside versus upside before taking a position.

Basic Formula

A common form is:

If the potential loss is $100 and the potential gain is $300, the ratio is:

That is often described as 1:3, meaning one unit of downside for three units of upside.

Why Traders Use It

Risk-reward ratio helps structure decisions around:

• entry price
• stop-loss location
• target price
• position sizing discipline

Instead of taking a trade and hoping it works, the trader defines the downside and upside in advance.

Why a Good Ratio Is Not Enough

This is one of the most important points.

A favorable risk-reward ratio by itself does not make a trade good. It must be paired with a realistic probability of success.

A trade offering 1:5 upside-to-downside may still be poor if it almost never reaches the target.

That is why serious traders think in terms of both:

• payoff ratio
• probability of winning

Risk-Reward Ratio vs. Risk-Adjusted Return

Risk-reward ratio is forward-looking and setup-specific. It is usually used before or during a trade plan.

Risk-adjusted return is broader and is often used after performance data exists, or across portfolios and managers.

So the two ideas are related, but not interchangeable.

Worked Example

A trader plans to buy a stock at $50, place a stop at $47, and aim for a target of $59.

• risk per share: $3
• expected gain per share: $9

Then:

The risk-reward ratio is 1:3.

Why It Helps With Discipline

Even when it does not guarantee success, the ratio helps prevent sloppy behavior such as:

• taking small upside for large downside
• moving stops emotionally
• entering trades without a clear exit framework

That makes it useful not just mathematically, but behaviorally.

Related Terms

• Risk-Adjusted Return: A broader framework for judging performance after risk is considered.
• Rate of Return: The realized or expected return figure the trade is trying to produce.
• Sharpe Ratio: A more formal portfolio-level risk-return comparison metric.
• Sortino Ratio: Focuses specifically on downside risk.
• Value at Risk (VaR): A different risk tool used for loss estimation rather than setup planning.

FAQs