Calculating Risk and Reward

how to calculate risk reward ratio

However, a ratio that is too low should be met with suspicion. Investors should consider their risk tolerance and investment goals when determining the appropriate ratio for their portfolio. Diversifying investments, the use of protective put options, and using stop-loss orders can help optimize your risk-return profile. This is why some investors may approach investments with very low risk/return ratios with caution, as a low ratio alone does not guarantee a good investment. The risk/reward ratio marks the prospective reward an investor can earn for every dollar they risk on an investment. Many investors use risk/reward ratios to compare the expected returns of an investment with the amount of risk they must undertake to earn these returns.

how to calculate risk reward ratio

You have $500 to put toward this investment, so you buy 20 shares. You did all of your research, but do you know your risk-reward ratio? If you’re like most individual investors, you probably don’t. The calculation for a long (buy) trade follows the same logic.

Margin trading and leverage are powerful tools in the arsenal of online traders. At its essence, margin trading allows traders to borrow funds to… The risk/reward tool in Trading View has been very helpful in formulating and refining my strategy.

A trade with a risk/reward ratio of 1 is more likely to result in the target being reached than a trade in which the risk/reward ratio is 0.1. A trendline is used to estimate where an area of support could develop. Wait for the price to stop falling (during an uptrend) showing the pullback may be over (there are no guarantees in trading). Once the price begins to move back higher, a long entry (buy) is taken, with a stop-loss placed below the recent low.

How Does Risk/Reward Ratio Work?

The risk/reward ratio is a tool investors can use to compare the potential profits and losses of an investment. The profit target is set at a location that is within reach based on normal market movements. In Figure 1., the price is moving within a trend channel.

Now it’s easy to calculate your potential risk reward ratio. Because you can have a 1 to 0.5 risk reward ratio, but if your win rate is high enough… you’ll still be profitable in the long run. The risk/reward ratio measures the potential profit an investment can produce for every dollar of losses the trade poses for an investor. Estimating the expected return and potential loss is not an exact science, and the actual amount of risk and return may differ from your estimates. Note that the risk/return ratio can be computed as one’s personal risk tolerance on an investment, or as the objective calculation of an investment’s risk/return profile.

  1. If your stop loss is too tight, then your trade doesn’t have enough room to breathe.
  2. Don’t be fooled by the risk reward ratio — it’s not what you think.
  3. The more price “obstacles” are in the way from the entry to the potential target, the higher the chances that the price will bounce along the way and not reach the final target.

Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem. Unless you’re an inexperienced stock investor, you would never let that $500 go all the way to zero. You notice that XYZ stock is trading at $25, down from a recent high of $29. We have been trading for over 15 years and during that time, tested hundreds of resources and trading tools.

Limiting Risk and Stop Losses

If the price is below the 200-period moving average such as 10-day, 20-day, or 100-day, look for short setups. In fact, you’re probably ahead of 90% of traders out there as you clearly know what’s not working. So… you’ve learned how to set a proper stop loss and target profit. But generally, you want to set a target at a level where there’s a good chance the market might reverse from — which means you expect opposing pressure to come in. So out of 10 trades, you have 8 losing trades and 2 winners. Investing money into the markets has a high degree of risk and you should be compensated if you’re going to take that risk.

If you are using Tradingview, you can also just use their Long / Short Position tool to draw in your reward-to-risk ratio automatically without doing any calculations. Because in the next section, you’ll learn how to analyze your risk to reward like a pro. This technique is useful for a healthy or weak trend where the price tends to trade beyond the previous swing high before retracing lower (in an uptrend). Don’t aim for the absolute highs/lows for your target because the market may not reach those levels, and then reverse. This means if your risk is $100 per trade and your stop loss is 200 pips, then you’ll need to trade 0.05 lots.

TradingView’s Fibonacci extension tool doesn’t come with 127 and 138 levels. Instead, you want to lean against the structure of the markets that act as a “barrier” that prevents the price from hitting your stops. Because the risk-reward ratio is only part of the equation. Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance.

The highway technique that improves your risk to reward

Practice many trades in a demo account to see what works for you in terms of risk and reward. Practicing is also required to gain skill in choosing your stop-loss locations and profit target levels to maximize your win rate for that trade setup and risk/reward ratio. The risk/reward ratio helps investors manage their risk of losing money on trades.


Even if a trader has some profitable trades, they will lose money over time if their win rate is below 50%. The risk/reward ratio measures the difference between a trade entry point to a stop-loss and a sell or take-profit order. Comparing these two provides the ratio of profit to loss, or reward to risk.

This allows the risk/reward ratio to provide a quick insight into whether an investment is worth making. This is popular with day traders who want to move in and out of the market quickly as it lets them make decisions about how much to risk to generate a potential gain. The risk/return ratio helps investors assess whether a potential investment is worth making. A lower ratio means that the potential reward is greater than the potential risk, while a high ratio means the opposite.

But there is so much more to the reward-to-risk ratio as we will explore in this article. In the trading example noted above, suppose an investor set a stop-loss order at $18, instead of $15, and they continued to target a $30 profit-taking exit. That’s because the stop order is proportionally much closer to the entry than the target price is.

In the latter case, expected return is often used in the denominator and potential loss in the numerator. The risk/reward ratio is often used as a measure when trading individual stocks. The optimal risk/reward ratio differs widely among various trading strategies. Some trial-and-error methods are usually required to determine which ratio is best for a given trading strategy, and many investors have a pre-specified risk/reward ratio for their investments. In the case of the former, the stop-loss and target are both the same distance away from the entry price.

However, this reduces your trading opportunities as you’re more selective with your trading setups. If you’re trading chart patterns, then your stop loss should be at a level where your chart pattern gets “destroyed”. If your stop loss is too tight, then your trade doesn’t have enough room to breathe. And you’ll probably get stopped out from the “noise” of the market — even though your analysis is correct.

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