Risk-Reward Ratio

The ratio comparing how much a trader stands to lose if a trade fails against how much they stand to gain if it succeeds, used to judge whether a setup is worth taking.

The risk-reward ratio compares the distance from entry to the stop-loss (the risk) against the distance from entry to the profit target (the reward). A trade risking one dollar to make three has a 1:3 risk-reward ratio. It is calculated before entry from the planned stop and target, and is one of the core filters disciplined traders apply to every setup — alongside position sizing, which is derived from the risk side of the same trade.

The ratio interacts directly with win rate to determine profitability. A strategy that wins only 40 percent of the time is still profitable at 1:3 risk-reward, because the winners more than cover the losers; conversely, a strategy that wins 70 percent of the time can still lose money at 1:0.5. Many traders require a minimum ratio — commonly 1:2 or better — so they need to be right less than half the time to come out ahead over a series of trades.

The ratio's main limitation is that the reward is hypothetical — the target may never be reached — while the risk is real and frequently hit. A seductively high ratio like 1:10 often means the target is unrealistically far away, lowering the true probability of success; the honest version weights the ratio by the probability of each outcome, which is the trade's expected value. Risk-reward is most useful combined with a realistic win-rate estimate and sensible stop placement, not as a number to maximize in isolation.

This definition is for informational and educational purposes only. Nothing on Finance Compass constitutes financial, investment, or trading advice. Always conduct your own research and consult a qualified professional before making financial decisions.