Understanding Risk-Reward Ratio

Risk-Reward Ratio is one of the most important concepts in trading and investing. It measures how much profit you can potentially make relative to how much you could lose on a trade. Professional traders never enter a trade without calculating this ratio first.

How to Calculate Risk-Reward Ratio

The formula is simple:

Risk-Reward Ratio = Potential Profit / Potential Loss

Where:

Potential Profit = Target Price - Entry Price
Potential Loss = Entry Price - Stop Loss Price

Example Calculation

Let's say you want to buy a stock:

Entry Price: ₹100
Target Price: ₹130
Stop Loss: ₹92

Potential Profit: ₹130 - ₹100 = ₹30
Potential Loss: ₹100 - ₹92 = ₹8
Risk-Reward Ratio: ₹30 / ₹8 = 3.75 or 1:3.75

This means you're risking ₹8 to potentially make ₹30 - an excellent ratio!

What is a Good Risk-Reward Ratio?

Ratio	Assessment	Breakeven Win Rate
Below 1:1.5	❌ Avoid	> 40%
1:1.5 to 1:2	⚠ Below Average	33-40%
1:2 to 1:3	✓ Good	25-33%
Above 1:3	✓✓ Excellent	< 25%

💡

Professional Standard

Most professional traders maintain a minimum 1:2 risk-reward ratio. Some aggressive traders may accept 1:1.5, but never go below this unless you have a very high win rate system.

Understanding Breakeven Win Rate

Breakeven win rate is the minimum percentage of trades you must win to not lose money:

Breakeven Win Rate = Risk / (Risk + Reward) × 100

Example: For a 1:2 risk-reward ratio:

Breakeven Win Rate = 1 / (1 + 2) × 100 = 33.3%

This means you only need to win 33.3% of your trades (1 out of 3) to break even. Win more than 33.3%, and you're profitable!

Why Risk-Reward Matters More Than Win Rate

Many beginners focus on win rate, but risk-reward is more important. Consider these two traders:

Trader A: High Win Rate, Poor Risk-Reward

Win Rate: 70% (7 winning trades out of 10)
Risk-Reward: 1:0.5 (risks ₹1,000 to make ₹500)
Result: 7 wins × ₹500 = ₹3,500 profit | 3 losses × ₹1,000 = ₹3,000 loss
Net Profit: ₹500 (barely profitable)

Trader B: Lower Win Rate, Good Risk-Reward

Win Rate: 40% (4 winning trades out of 10)
Risk-Reward: 1:3 (risks ₹1,000 to make ₹3,000)
Result: 4 wins × ₹3,000 = ₹12,000 profit | 6 losses × ₹1,000 = ₹6,000 loss
Net Profit: ₹6,000 (12x more than Trader A!)

✅

Key Insight

Trader B is 12 times more profitable despite a lower win rate! Good risk-reward allows you to be profitable even when you're wrong more often than you're right.

How to Set Stop Loss and Target

Setting Stop Loss

Technical Support: Below key support levels or recent lows
Percentage Method: 2-3% below entry for swing trades, 5-8% for investments
Volatility-Based: Use ATR (Average True Range) for volatile stocks
Pattern-Based: Below breakout point or trendline

Setting Target

Technical Resistance: Previous highs, resistance levels
Measured Move: Project the height of pattern upward
Multiple Targets: Book partial profits at 1:2, trail rest for 1:4+
Round Numbers: Stocks often face resistance at psychological levels

Risk Management Rules

Never Risk More Than 2%: Don't risk more than 2% of capital per trade
Set Stop Loss First: Before entering, know your exit if wrong
Position Sizing: Adjust position size based on stop loss distance
Minimum 1:2 Ratio: Never take trades with ratio below 1:2
Honor Your Stop Loss: Don't move it further away when hit
Asymmetric Bets: Look for trades where reward is much higher than risk

Position Sizing Example

Let's calculate position size with proper risk management:

Account Size: ₹5,00,000
Risk Per Trade: 2% = ₹10,000
Entry Price: ₹200
Stop Loss: ₹190
Risk Per Share: ₹10

Position Size = Risk Amount / Risk Per Share
Position Size = ₹10,000 / ₹10 = 1,000 shares
Total Investment = 1,000 × ₹200 = ₹2,00,000

Even though this requires ₹2 lakhs, you're only risking ₹10,000 (2% of capital) because of your stop loss. This is how professionals size positions.

Common Mistakes to Avoid

Trading Without Stop Loss: Recipe for disaster, one bad trade wipes out account
Moving Stop Loss Away: Violates your original risk-reward calculation
Taking Low Ratios: Need unrealistic 60-70% win rate to be profitable
Ignoring Risk Amount: Focusing only on potential profit
Oversizing Positions: Taking too large positions without considering risk
No Consistent Approach: Randomly setting stops and targets

Advanced Risk-Reward Strategies

Scaling Out

Book partial profits at 1:2, then trail stop loss for remaining position to capture 1:4, 1:6 or more.

Risk-Free Trade

Once price reaches 1:2, move stop loss to entry price. Now you can't lose money even if trade reverses.

Trailing Stop Loss

After target is hit, trail stop loss below each new swing low to capture extended moves.

⚠️

Reality Check

Good risk-reward doesn't guarantee profit on every trade. You will still have losses. But over many trades, superior risk-reward ratios ensure profitability even with modest win rates.

Risk-Reward Ratio Calculator