Risk reward ratio explained and why it matters more than win rate

In financial trading, the risk reward ratio plays a crucial role in determining a trader’s long-term sustainability in the market. Even with accurate entry points, an imbalanced risk reward ratio can still cause an account to deteriorate over time. In this article, pfinsight.net explains how to build an effective risk reward ratio, helping traders limit losses and maintain long-term trading discipline.

What is the risk reward ratio?

The risk reward ratio, or R/R ratio, is an indicator that assesses the expected return relative to the risk involved in a trade, thereby helping traders manage risk and optimize investment performance.

The risk reward ratio is determined by comparing the distance from the entry point to the stop-loss level with the distance from the entry point to the take-profit target. This calculation helps traders estimate the level of risk relative to the expected profit. However, when combined with other risk management tools, this ratio helps assess whether a trade is in line with the trading plan.

Why do traders need to pay attention to the risk versus reward ratio?

Using the risk reward ratio helps traders measure the potential return of an investment relative to an acceptable loss. This is a crucial foundation for building risk management strategies and maintaining consistent trading performance.

Supporting effective investment decisions: The risk reward ratio helps investors make more accurate decisions when choosing investment opportunities. Through this indicator, they can assess the feasibility of each specific investment. In addition, the risk/reward ratio helps compare different opportunities by matching the level of risk to the expected return of each investment option.
Expected profit level: A reasonable risk/reward ratio allows traders to maintain profitability even when the number of winning trades is not high. For example, with a ratio of 1:3, a trader can still make a profit by winning only 1 out of 4 trades, as long as the average profit is large enough to offset the remaining losses.
Developing a trading strategy: By evaluating the risk reward ratio, traders can develop a trading strategy that suits their personal financial goals. For example, an investor aiming for a 1:5 ratio will adjust entry points, stop-loss orders, and take-profit orders to maintain this balance, thereby forming a more disciplined and consistent trading habit.
Risk control: Mastering the risk reward ratio (R/R) plays a crucial role in controlling trading risk. This allows traders to determine appropriate stop-loss and take-profit positions, limiting losses while maximizing profit opportunities.
Stability in trading: By focusing on the risk reward ratio, investors can build and maintain a more disciplined trading approach, while limiting emotional or impulsive decisions driven by psychology.

How to calculate the R/R ratio

To determine the risk-reward ratio, traders first need to calculate the risk and potential reward of each trade separately. Specifically:

Risk/reward ratio (R/R ratio) = (Entry point – Stop loss point) / (Takeprofit point – Entry point)

In there:

Risk: Risk is the maximum loss a trader is willing to accept for a trade, determined by a stop-loss order. This value is the difference between the entry point and the established stop-loss level.
Profit: Profit is the expected return on a trade, determined based on a predetermined profit target, which is the price at which the investor expects to exit the trade to realize the profit.

For example: Suppose you place a buy order for a stock at $120, setting a profit target at $150 and a stop loss at $110.

Potential profit: 150 − 120 = 30 USD
Potential risk: 120 − 110 = 10 USD

In this case, the risk/reward ratio is 3:1 ($30/$10), meaning that for every $1 risk taken, the trader has the opportunity to earn $3 in profit. This ratio is often preferred because the expected profit significantly outweighs the potential loss.

What risk reward ratio is considered ideal in trading?

There is no ideal risk reward ratio for every trader, as this ratio is heavily influenced by trading strategy, risk tolerance, and specific market conditions.

The general principle is to prioritize trades where the potential profit significantly outweighs the risk involved. Ratios lower than 1:1 are often not attractive enough in terms of expected profit. Conversely, excessively high ratios like 10:1 may be unrealistic, as the market rarely generates enough volatility to consistently achieve that target.

In practical trading, a risk reward ratio (R/R) between 1:1.5 and 1:3 typically provides optimal balance. This level allows traders sufficient profit margin without excessive risk. Simultaneously, it effectively helps control losses, limiting reckless decisions that could lead to rapid account depletion.

During periods of high market volatility, such as when impacted by significant economic news or approaching key support and resistance levels, aiming for a higher risk-reward ratio may be reasonable. However, such trades require traders to apply rigorous risk management, including accurately calculating trade volume, setting appropriate stop-loss levels, and maintaining psychological control throughout the trading process.

Tips for using the risk reward ratio effectively

To effectively apply the risk reward ratio (R/R) in trading, traders need to adhere to several important principles to optimize profits and better control risk.

Determine your personal risk tolerance: Before placing an order, investors need to assess their maximum acceptable loss. This helps in choosing an appropriate risk-reward ratio and avoiding trades that exceed their risk limits.
Adjust the Risk/Reward ratio according to the asset and strategy: Each market and trading style has its own characteristics, so a fixed risk/reward ratio should not be applied. Short-term trading generally accepts a higher risk/reward ratio, while long-term trading prioritizes a more stable and realistic risk/reward ratio.
Set clear stop-loss and take-profit orders: Setting stop loss and take-profit from the outset helps traders determine the maximum loss and expected profit for each trade in advance, thereby calculating the risk-reward ratio more accurately and objectively.
Adjust position size appropriately: Order size should be adjusted based on the risk/reward ratio and individual risk tolerance. This approach helps ensure potential losses remain within acceptable limits while protecting the account from adverse market fluctuations.
Utilizing tools to calculate the risk/reward ratio: Investors should take advantage of available tools, software, or trading platforms to quickly and accurately calculate and monitor the risk/reward ratio, thereby making decisions based on specific data.
Regularly reviewing trading performance: Regularly checking executed trades, analyzing the risk-reward ratio and results helps traders identify weaknesses, adjust strategies, and improve risk management methods in the long term.
Maintain strict trading discipline: Traders need to adhere closely to their established trading plan, including entry points, stop-loss orders, and take-profit orders, to ensure the risk-reward ratio is consistently applied.
Control your emotions when trading: Avoid letting psychological factors such as greed, fear, or impatience influence your decisions. Each trade should be placed based on analysis and discipline, not emotional reactions, in order to optimize the effectiveness of the risk-reward ratio in the long term.

Conclude

Understanding and applying the risk reward ratio correctly plays a crucial role in every trader’s success. An effective trading strategy does not require a high win rate; instead, it relies on a favorable risk reward ratio that can offset inevitable losses. When combined with proper money management and trading discipline, the risk reward ratio helps traders reduce psychological pressure and steadily improve overall trading performance.