Learning to manage risk effectively is key to success as a trader. Good risk management helps minimize your losses and preserves the gains from your winning trades. By understanding the risk/reward ratio of any individual trade, you can better decide which setups to pursue and maximize your net profits.
In this guide, we’ll explain the concept of risk/reward in trading and how you can use it to manage your trading risk.
The Importance of Managing Risk as a Trader
Trading is about more than just winning trades. It’s also about managing risk and minimizing losses. The better you are at keeping losses small, the more you can boost your net profits from your winning trades.
The importance of managing risk is underscored by the fact that a trader who wins just half of their trades can be profitable. The key is to keep your average loss smaller than your average profit.
What is Risk/Reward?
The risk/reward ratio is a measure of how much you stand to profit for every dollar you risk on a trade. It provides a measurement of the potential risk and reward for every trade, allowing you to objectively compare potential trades and refine your overall trading strategy.
Using risk/reward ratios effectively requires you to know what a good risk/reward ratio is. A 1:1 ratio means that you’re risking as much money if you’re wrong about a trade as you stand to gain if you’re right. This is the same risk/reward ratio that you can get in casino games like roulette, so it’s essentially gambling. Most experienced traders target a risk/reward ratio of 1:3 or higher.
How to Calculate Risk/Reward
Calculating the risk/reward ratio for a trade requires that you know your entry price, your price target, and your stop loss. Your risk is equal to the difference between your entry and stop loss – that is, the amount you’ll lose if your trade stops out. Your reward is equal to the difference between your price target and entry price – that is, the amount you’ll gain if your trade goes according to plan.
To give an example, say you’re interested in trading shares of Apple. You plan to enter a position at $165 per share and think the price will rise to $180. So, your reward is $15 per share ($180 – $165). To limit your downside, you set a stop loss at $160 per share. So, your risk is $5 per share ($165 – $160). Your risk/reward ratio for the trade is 1:3 ($5/$15).
Considerations for Trading with Risk/Reward in Mind
When using risk/reward ratios as part of your approach to trading, there are a few important things to keep in mind.
First, your risk and reward need to be realistic and accurate. Don’t always determine your price target and stop loss based on a desired 1:3 risk/reward ratio. Rather, you can determine your price target and stop loss first and then calculate your risk/reward ratio.
Your price target could be based on a specific resistance level or technical indicator, and your stop loss could be placed below a support level. Look back at your past trades or setups to see how they evolved and determine what your price target and stop loss levels should be.
Importantly, for the risk/reward ratio to be meaningful, you have to stick to your trading plan. If you don’t fully commit to exiting a trade at your stop loss price, then your potential risk is unlimited.
It’s also important to be realistic about whether a trade will work. To go back to the example of Apple shares above, you could achieve a 1:15 risk/reward ratio if you set your stop loss at $164. However, the likelihood that your trade will stop out before achieving your price target is much higher. Think carefully about volatility and support levels when determining what stop loss to use for a trade.
Finally, make sure to think about the amount of money you’re risking in addition to your risk/reward ratio. The amount of money you risk is determined by the size of your position. So, choose a position size that you’re comfortable with in the context of your risk/reward ratio.
Conclusion
The risk/reward ratio of a trade is an objective way to measure how much money you stand to make per added dollar of risk. You can use risk/reward ratio to compare setups and to manage your overall risk while trading. When using risk/reward ratio, be careful about choosing realistic price targets and stop losses. Also remember that your position size determines the amount of money you are putting at risk in any trade. Lastly, the only effective risk/reward strategy is the one that you abide by not matter what your emotions tell you to do.
The information contained herein is intended as informational only and should not be considered as a recommendation of any sort. Every trader has a different risk tolerance and you should consider your own tolerance and financial situation before engaging in day trading. Day trading can result in a total loss of capital. Short selling and margin trading can significantly increase your risk and even result in debt owed to your broker.Please review ourday trading risk disclosure,margin disclosure, andtrading feesfor more information on the risks and fees associated with trading.
FAQs
The risk-reward ratio is calculated by dividing an investment or trade's potential profit or reward by the potential loss or risk. For example, if the potential gain is $1,000 and the possible loss is $500, the risk-reward ratio would be 2:1 ($1,000/$500). How does the risk-reward ratio impact investment strategies?
What is the best risk reward for day trading? ›
How the Risk/Reward Ratio Works. In many cases, market strategists find the ideal risk/reward ratio for their investments to be approximately 1:3, or three units of expected return for every one unit of additional risk.
What is the risk reward in trading 101? ›
Your risk is equal to the difference between your entry and stop loss – that is, the amount you'll lose if your trade stops out. Your reward is equal to the difference between your price target and entry price – that is, the amount you'll gain if your trade goes according to plan.
What is the risk reward 1 3 strategy? ›
Risk-Reward Ratio (1:3): For every trade you take, you are willing to risk 1 unit of your capital (e.g., $100) to potentially gain 3 units (e.g., $300) if the trade goes in your favor. Now, let's consider the win rate: 2. Win Rate: This represents the percentage of your trades that are profitable.
What is the best risk-reward ratio in trading? ›
In order to make money trading this setup in the long run, your rewards need to be greater than risks. Keep in mind that there are also trading and non trading fees that need to be covered. Ideally, when the success rate is 50%, the risk to reward ratio should be 1:2 or greater.
What is the best risk-reward ratio for scalping? ›
For any stock you plan to scalp, you must understand the price supports, resistances and the set-up. From there, you can calculate the share sizing and the probabilities versus the risk. In scalping, a 3:1 risk to reward ratio is common (although, lower risk/reward is always more favorable).
What is the number one rule in day trading? ›
The 1% risk rule means not risking more than 1% of account capital on a single trade. It doesn't mean only putting 1% of your capital into a trade. Put as much capital as you wish, but if the trade is losing more than 1% of your total capital, close the position.
What is the most successful day trading pattern? ›
The best chart patterns for day trading include the triangle, flag, pennant, wedge, and bullish hammer chart patterns.
What is the secret to successful day trading? ›
Success in day trading requires a deep understanding of market dynamics, the ability to analyze and act on market data quickly, and strict discipline in risk management. The profitability of day trading depends on several factors, including the trader's skill, strategy, and the amount of capital they can invest.
How do you calculate risk reward ratio in day trading? ›
By taking the average earnings per successful trade and setting it against the average loss from the unsuccessful ones, you get the Risk-Reward Ratio.
Your strategy has a greater probability of success with a 3:1 risk -reward ratio than with a 1:1 risk reward ratio . Always remember that what matters in the long run is consistency and developing a strategy with a highly favorable risk-reward ratio will do along way in achieving this .
What is R in trading? ›
R-Multiple: our profit or loss on a trade divided by the amount we intended to risk. If we risk $500 and make $2000 (2000/500), that is a 4R trade. If didn't place a stop loss and lost $750 when we were only supposed to lose $500, that is a -1.5R trade (750/500).
What is the 1 3 2 strategy? ›
The 1-3-2 structure supposedly appears as a tree. The strategy profits from a small increase in the price of the underlying asset and maxes when the underlying closes at the middle option strike price at options expiration. Maximum profit equals middle strike minus lower strike minus the premium.
What should be the risk-reward ratio for beginner? ›
Industry professionals often cite 2:1 as the optimal risk-reward ratio for beginners. That would work, for example, by setting a take-profit order at twice the value of the stop-loss. This could be used alongside other risk-management strategies.
What is a 2 1 risk-reward? ›
In this example, the risk-reward ratio is 2:1, which means the trader stands to make twice as much profit as they could potentially lose.
How to calculate risk formula? ›
Risk is the combination of the probability of an event and its consequence. In general, this can be explained as: Risk = Likelihood × Impact. In particular, IT risk is the business risk associated with the use, ownership, operation, involvement, influence and adoption of IT within an enterprise.
What is a 2 to 1 risk-reward ratio in trading? ›
A positive reward:risk ratio such as 2:1 would dictate that your potential profit is larger than any potential loss, meaning that even if you suffer a losing trade, you only need one winning trade to make you a net profit.
What is the 1.5 risk-reward ratio? ›
The 1.5 Risk-Reward Ratio: Balancing Risk and Reward
A commonly cited benchmark in trading is the 1.5 risk-reward ratio. This ratio suggests that for every unit of risk taken (usually measured as a percentage or dollar amount), an investor should aim for a potential reward that is one and a half times greater.
What is a 2 to 1 risk-reward ratio? ›
In this example, the risk-reward ratio is 2:1, which means the trader stands to make twice as much profit as they could potentially lose.
