Ever risked ₹1,000 to earn just ₹500?
That’s not trading — that’s a donation to the market.
In our previous article, we discussed the importance of Position Sizing — knowing how much capital to put on the line in each trade. But there’s another equally critical concept that works hand-in-hand with it: Risk-Reward Ratio.
What is the Risk-Reward Ratio ?
The **Risk-Reward Ratio** (R:R) is a fundamental metric in trading that compares your potential loss on a trade to your potential profit. It helps you assess whether a trade is worth taking before you even enter.
Formula:
Risk-Reward Ratio = Potential Loss : Potential Profit
A high **Risk-Reward Ratio** (e.g., 1:3) means you risk a small amount to potentially gain a large amount, while a low ratio (e.g., 2:1) means you risk more than you stand to gain.
Example:
| Risk | Reward | Ratio | Interpretation |
|---|---|---|---|
| ₹500 | ₹1,500 | 1:3 | Good (aim to gain 3x your risk) |
| ₹1,000 | ₹500 | 2:1 | Not ideal (risking more than you aim to gain) |
Calculating Your Risk to Reward Ratio (Step-by-Step)
To accurately calculate your **Risk-Reward Ratio**, you need three key price points for your planned trade:
- Entry Price: The price at which you plan to open your trade.
- Stop Loss (SL) Price: The price at which you will exit to limit your loss. (Refer to our guide on Stop Loss and Target Setting for more details).
- Target Price: The price at which you plan to exit to take profit.
Steps:
- 1. Calculate Potential Loss (Risk Unit): `|Entry Price – SL Price|`
- 2. Calculate Potential Profit (Reward Unit): `|Target Price – Entry Price|`
- 3. Form the Ratio: `(Potential Loss) : (Potential Profit)`
Example: You plan to buy Stock X at ₹100, with an SL at ₹97 and a Target at ₹109.
Potential Loss = |100 – 97| = ₹3
Potential Profit = |109 – 100| = ₹9
Risk-Reward Ratio = ₹3 : ₹9 = 1:3
The Power of a Favorable Ratio
A strong **Risk-Reward Ratio** is a cornerstone of sustainable profitability, even if your win rate isn’t exceptionally high. It’s about making your wins count more than your losses.
Let’s say you take 10 trades with a 1:3 **Risk-Reward Ratio**:
- 4 wins × ₹1,500 = ₹6,000
- 6 losses × ₹500 = ₹3,000
- Net Profit = ₹3,000
This illustrates the concept of **Expectancy**, which is the average profit or loss you can expect per trade over a large number of trades. With a positive expectancy (driven by a good **Risk-Reward Ratio**), profitability becomes a mathematical certainty over time, despite individual losses. A consistent **Risk-Reward Ratio** strategy helps overcome the emotional impact of losing trades, as you know your overall plan is sound.
The Duo: Risk-Reward and Position Sizing
**Risk-Reward Ratio** and Position Sizing are two sides of the same coin in effective risk management. They work hand-in-hand to protect your capital and ensure consistent growth.
- **Position Sizing** controls *how much capital you risk* on any single trade (e.g., 1-2% of your total capital).
- **Risk-Reward Ratio** defines *why that risk is worth taking* by comparing potential gain to potential loss.
Together, they build the foundation of a solid, professional trading plan. For example, if your max risk per trade is ₹1,000 and your SL is ₹10, you can take a position of 100 shares. If this trade has a 1:3 **Risk-Reward Ratio**, your target profit is ₹30 per share, aiming for a ₹3,000 profit.
How to Set Your Ratio for a Trade
Determining your **Risk-Reward Ratio** isn’t arbitrary; it stems from your analysis and trading strategy. Here’s how to logically set your SL and Target to achieve a favorable ratio:
- Technical Levels: Your Stop Loss should be placed at a logical technical level (e.g., below a recent swing low, support zone, or trendline break). Your Target should be set at a logical resistance level or based on a pattern’s measured move.
- Volatility (ATR): Use indicators like Average True Range (ATR) to set a dynamic Stop Loss that accounts for the stock’s typical volatility, preventing premature exits.
- Time Frame: Your **Risk-Reward Ratio** might vary with your trading style. Intraday traders might aim for 1:1.5 to 1:2, while swing or positional traders might target 1:3 or higher due to wider price movements.
- Strategy-Based: Your specific **trading strategy** should have predefined rules for where SL and Targets are placed, ensuring consistency in your **Risk-Reward Ratio**.
Dynamic Trade Management with Your Ratio
Your **Risk-Reward Ratio** doesn’t just apply at entry; it guides your trade management:
- **Trailing Stop Loss:** As the trade moves in your favor, consider trailing your Stop Loss. For example, once the price moves past your 1:1 **Risk-Reward Ratio** point, you might move your SL to your entry price (breakeven) to eliminate risk.
- **Partial Profit Booking:** If aiming for a 1:3 or 1:4 **Risk-Reward Ratio**, you can book partial profits at 1:1 or 1:2. This locks in some gains and reduces risk on the remaining position.
- **Adherence to Plan:** The **Risk-Reward Ratio** reinforces the discipline of sticking to your pre-defined exit points, preventing emotional decisions.
Avoiding Common Pitfalls
Even experienced traders can make mistakes related to **Risk-Reward Ratio**:
- **Forcing the Ratio:** Trying to achieve a 1:3 or 1:4 ratio by setting an unrealistic target or an absurdly tight Stop Loss, leading to frequent Stop Loss hits.
- **Ignoring in Losing Trades:** Letting a losing trade run beyond the calculated risk, turning a small loss into a major drawdown, effectively making the **Risk-Reward Ratio** infinite in reverse.
- **Only Calculating for Wins:** Overlooking the collective impact of losses and not continuously tracking the average **Risk-Reward Ratio** across all trades.
- **Not Adapting to Market Conditions:** Applying the same fixed **Risk-Reward Ratio** in choppy markets as in trending markets, which can lead to poor results.
Pro Tip (Revisited)
Never enter a trade without knowing:
- Where your stop-loss is (your maximum acceptable loss)
- Where your target is (your expected profit level)
- And whether the **Risk-Reward Ratio** justifies the risk (is the potential reward significantly larger than the potential risk?)
Aim for a minimum of 1:2, and whenever possible, look for 1:3 or higher, especially in **swing trading** and **positional trading** where bigger moves are expected. This systematic approach forms a strong trading plan and enhances your risk management.
Conclusion
**Risk-Reward Ratio** is not just a metric; it’s a fundamental principle of sustainable **trading**. By consistently ensuring your potential gains outweigh your potential losses, you set yourself up for long-term success, even if every trade isn’t a winner. It’s a critical component of any robust trading strategy and a cornerstone of effective risk management.