Understanding Risk / Reward Ratio

What is the Risk/Reward Ratio?

The risk/reward ratio (or R-Multiple) measures how much your potential reward is for every dollar you risk on a trade. It is the core mathematical foundation of profitable trading because it dictates your required win rate. If your average reward is exactly the same as your average risk (a 1:1 ratio), you must maintain a win rate of greater than 50% just to break even. As your R-Multiple increases, your required win rate drastically decreases.

The Mathematical Formula

The formula calculates the difference between your entry and target (the reward), divided by the difference between your entry and stop loss (the risk):

Practical Trading Scenario

Assume you buy a stock at $50.00. You identify a structural invalidation level below at $48.00 where you will exit if you are wrong (your stop loss). You also identify a major resistance zone overhead at $56.00 where you plan to take profits (your target).

Your risk is $2.00 per share ($50 - $48), while your potential reward is $6.00 per share ($56 - $50). Dividing $6.00 by $2.00 yields an R-Multiple of 3.00 R (or a 1:3 Risk/Reward ratio). This means that for every dollar you risk losing, you stand to make three dollars. With a strict 1:3 ratio, you can lose 70% of your trades and still not lose money.