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Risk to Reward
Risk-to-reward compares the amount a trader is prepared to lose on a trade with the amount they hope to gain. It is an important planning tool because it helps traders evaluate whether a potential trade makes sense before entering.
What Is Risk-to-Reward?
Risk-to-reward compares the potential amount that could be lost with the potential amount that could be gained.
It is commonly written as a ratio, such as 1:1, 1:2 or 1:3.
The first number represents planned risk. The second number represents potential reward.
Simple Example
Imagine a trader enters a position at $100, places a Stop Loss at $95 and sets a Take Profit at $110.
The planned risk is $5 and the potential reward is $10.
Understanding Common Ratios
Equal Risk and Reward
The potential gain is approximately equal to the planned loss.
Reward Is Twice the Risk
The potential reward is approximately two times the amount at risk.
Reward Is Three Times the Risk
The potential reward is approximately three times the planned risk.
Why Risk-to-Reward Matters
Defines Risk
It encourages traders to understand potential loss before entering.
Defines a Target
It provides a planned area where profits may be taken.
Improves Consistency
Using a repeatable process can reduce emotional decisions.
Helps Evaluate Trades
Traders can compare potential reward with the amount being placed at risk.
Risk-to-Reward and Win Rate
Traders do not need every trade to be profitable for risk-to-reward to matter.
For example, a trader using a 1:2 structure may potentially make more on a winning trade than they lose on an individual losing trade.
Loss
Loss
Win
Win
This example is simplified and does not include fees, slippage, taxes or other trading costs. It does not imply future results.
Do Not Force a Ratio
Traders should not place unrealistic Take Profit levels simply to create an attractive risk-to-reward ratio.
Entry, Stop Loss and target levels should still make sense based on the market structure being analysed.
The Stop Loss Comes First
A useful approach is to first determine where the trade idea would no longer make sense.
The goal is not to find a target first and then manipulate the Stop Loss to create a preferred ratio.
Transaction Costs Matter
Real trading results can also be affected by costs such as spreads, commissions, financing charges and slippage.
These costs can change the actual risk and reward achieved compared with the original plan.
- Spread can affect entry and exit prices.
- Commissions can reduce net results.
- Slippage can change execution prices.
- Overnight costs may apply to some positions.
No Ratio Guarantees Profit
Risk-to-reward is a planning framework. It cannot tell a trader whether the next trade will win or lose.
Key Takeaways
- Risk-to-reward compares planned loss with potential gain.
- A 1:2 ratio means potential reward is twice the planned risk.
- Risk-to-reward helps structure trade planning.
- A larger ratio does not increase the probability of success.
- Stop Loss and target levels should be based on market structure.
- Transaction costs can affect actual outcomes.
- Risk-to-reward should be considered together with position sizing.
- No risk-to-reward ratio guarantees a profitable trade.
DADA Trading Academy materials are provided for general educational purposes only and do not constitute personalized financial, investment or trading advice. Trading involves risk and losses are possible.