Risk/Reward Ratio

Risk Management • 2 min read • Beginner

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Imagine you're playing a game of chance. You have a choice:

Option A: You bet $1 and have a chance to win $1.

Option B: You bet $1 and have a chance to win $3.

Which option would you choose? Most people would pick B, and for good reason. The Risk/Reward Ratio is the trading equivalent of this simple choice. It’s a tool that compares the amount you are risking on a trade to the amount you stand to gain. It’s a crucial part of risk management that separates disciplined traders from gamblers.

The ratio is calculated as: (Potential Loss) / (Potential Gain). A ratio of 1:3 means you are risking $1 to potentially make $3.

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Why Is It So Important?

A good risk/reward ratio allows you to be profitable even if you lose more trades than you win. This might sound counterintuitive, but it's a fundamental truth of successful trading.

Let's look at two scenarios:

Trader A (The Gambler): Only takes trades with a 1:1 risk/reward ratio. They win 60% of their trades and lose 40%.

Wins: 6 wins x $100 profit/win = $600

Losses: 4 losses x $100 loss/loss = -$400

Net Profit: $200

Trader B (The Disciplined Trader): Only takes trades with a 1:2 risk/reward ratio. They only win 40% of their trades and lose 60%.

Wins: 4 wins x $200 profit/win = $800

Losses: 6 losses x $100 loss/loss = -$600

Net Profit: $200

As you can see, even with a much lower win rate, Trader B achieved the same profit just by being more selective about their trades.

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How to Calculate Your Ratio

Calculating your risk/reward ratio is straightforward if you've already defined your entry, stop-loss, and profit target.

Potential Loss: The difference between your entry price and your stop-loss price.

Potential Gain: The difference between your entry price and your profit target.

Example: You Buy a Stock at: $50

Your Stop-Loss is at: $48 (Potential Loss = $2)

Your Profit Target is at: $56 (Potential Gain = $6)

Risk/Reward Ratio: $2 (Risk) / $6 (Reward) = 1:3

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The Rules of Thumb

Aim High: Most disciplined traders look for a risk/reward ratio of 1:2 or higher. This means for every dollar you're willing to lose, you should be aiming to make at least two dollars.

Don't Settle: Avoid trades with a ratio of 1:1 or less, as these require a very high win rate to be consistently profitable and are often a sign of poor planning.

By making the risk/reward ratio a central part of your trading plan, you shift your focus from simply winning to winning big and losing small. It's a key mindset change that can transform your trading.

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