risktoreward

Risk-to-reward is a framework used in investing and trading to compare the potential downside of a trade with its potential upside. It helps traders assess whether a proposed trade offers an acceptable balance of risk and reward and can inform decisions about entry, stop placement, and position sizing.

Calculation and interpretation: For a long trade, risk equals the entry price minus the stop-loss price, while potential reward equals the take-profit price minus the entry price. The risk-to-reward ratio is risk divided by reward. For a short trade, the same idea applies using price distances in the opposite direction. A ratio below 1 indicates that the potential reward exceeds the potential loss, while a ratio above 1 suggests the opposite. Many traders also express this as a reward-to-risk ratio, such as 2:1, meaning the potential reward is twice the potential risk.

Example: Enter a long position at 100, stop at 95 (risk = 5), take profit at 110 (reward = 10). The risk-to-reward ratio is 5/10 = 0.5 (or a 2:1 reward-to-risk setup). If the trader believes there is a 40% probability of reaching the target, the expected value is 0.4×10 − 0.6×5 = 1, a positive EV.

Limitations: The ratio does not predict success and relies on fixed price levels that may not hold. It omits probabilities, market conditions, slippage, and costs. It should be used alongside other metrics such as win rate, expectancy, and overall risk management.

See also: risk management, position sizing, stop loss, take profit, expectancy, win rate.