Risk-Reward Ratio is the ratio of the planned profit on a trade to the planned loss on the same trade, calculated at entry from the entry price, stop loss, and target price. A 1:2 risk-reward ratio means the trader is risking $1 to make $2 — the target is twice as far from entry as the stop. Combined with win rate, the risk-reward ratio determines whether a strategy has positive expectancy; neither number is meaningful alone.
Formula
For a long trade:
Risk-Reward Ratio = (Target Price − Entry Price) / (Entry Price − Stop Price)
For a short trade:
Risk-Reward Ratio = (Entry Price − Target Price) / (Stop Price − Entry Price)
Conventionally written as 1:X where X is the result. A ratio of 1:1.5 means you risk one unit to make 1.5.
Worked example
You buy AAPL at $190 with a stop at $186 and a target at $200.
Risk = $190 − $186 = $4 Reward = $200 − $190 = $10 Risk-Reward Ratio = $10 / $4 = 2.5, written as 1:2.5
To break even at this risk-reward ratio, you only need to win 1 out of every 3.5 trades — about a 28.6% win rate. Hit 40% and the system is comfortably profitable.
Why it matters
The breakeven win rate for a strategy is roughly 1 / (1 + Risk-Reward Ratio). At 1:1 you need above 50%; at 1:3 you need above 25%. This relationship lets you reverse-engineer the win rate threshold for any setup type and ditch trades whose realistic risk-reward cannot clear the bar.
Common pitfalls
A planned 1:3 ratio means nothing if you routinely close at 1:1 because the trade "stalled." The realized risk-reward, computed from actual exit prices, is what shows up in the journal — and it is almost always lower than the planned figure. Track both. Also, very high planned ratios (1:5+) often imply targets the market rarely reaches; verify with historical MFE data.