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
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 strategy of traders? ›
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. Investors can manage risk/reward more directly through the use of stop-loss orders and derivatives such as put options.
What is a good risk reward trading? ›
The general theory is that if the risk is greater than the reward, the trade will not be worth it. A good risk/reward ratio could be seen as greater than 1:3, where you would risk 1/4 of the overall potential profit.
What is a 1 to 3 risk reward ratio? ›
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 1 risk rule in trading? ›
The 1% rule demands that traders never risk more than 1% of their total account value on a single trade. In a $10,000 account, that doesn't mean you can only invest $100. It means you shouldn't lose more than $100 on a single trade.
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 formula for risk-reward? ›
To calculate risk-reward ratio, divide net profits (which represent the reward) by the cost of the investment's maximum risk. For instance, for a risk-reward ratio of 1:3, the investor risks $1 to hopefully gain $3 in profit. For a 1:4 risk-reward ratio, an investor is risking $1 to potentially make $4.
How much risk should I take per trade? ›
Always calculate your maximum risk per trade: Generally, risking under 2% of your total trading capital per trade is considered sensible. Anything over 5% is usually considered high risk.
What is the best risk percentage for trading? ›
The simplest and most effective way to protect your equity through risk management is to establish strict loss parameters and abide by them. One popular method is the 2% Rule, which means you never put more than 2% of your account equity at risk (Table 1).
What does 2R mean in trading? ›
Here's another example: Let's say you buy a stock priced at $500 and have a stop loss at $480, meaning that 1R is equal to $20. Then the stock's price increases to $540 and you take profit. You have taken $40 or 2R profit.
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 best risk-reward ratio for swing trading? ›
Generally, a 1:2 risk-reward ratio is favorable for short-swing trades.
What is the R multiple 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 5-3-1 rule in trading? ›
The 5-3-1 rule in Forex is a trading strategy based on three key principles: choosing five currency pairs to trade, developing three trading strategies, and choosing one time of day to trade.
What is the 3-5-7 rule in trading? ›
The 3–5–7 rule in trading is a risk management principle that suggests allocating a certain percentage of your trading capital to different trades based on their risk levels. Here's how it typically works: 3% Rule: This suggests risking no more than 3% of your trading capital on any single trade.
What is 90% rule in trading? ›
This rule encapsulates a stark reality: approximately 90% of individuals who venture into forex trading fail to achieve sustained success, while the remaining 10% flourish. It's important to recognize that this rule is not a rigid statistic but rather a general observation drawn from market dynamics and behaviors.
What is the risk per trade strategy? ›
Risk per trade should always be a small percentage of your total capital. A good starting percentage could be 2% of your available trading capital. So, for example, if you have $5000 in your account, the maximum loss allowable should be no more than 2%. With these parameters, your maximum loss would be $100 per trade.
What is the risk and reward approach? ›
The risk-reward framework is a structured approach to decision making that helps individuals analyze potential outcomes based on the balance between risk and reward.
What is the risk reward and win rate in trading? ›
If you have a high win rate, your risk to reward can be lower. You are profitable with a 60% win rate and a risk-to-reward of 1. Now, you will have more profit with a 60% win rate and a high risk-to-reward ratio. If you have a win rate of 50% or less, your winning trades should be higher than your losing trades.
What is the risk reward trade view? ›
The risk/reward ratio measures the difference between the entry point to a stop-loss and a sell or take-profit point. Comparing these two provides the ratio of profit to loss, or reward to risk.
