Risk Reward Ratio
The risk reward ratio (RRR) is a mathematical measure used in trading to compare the potential profit of a trade to its potential loss, expressed as a ratio of risk per unit of reward.
Quick Definition Box
The risk reward ratio quantifies how much a trader stands to lose for every unit of potential gain. A ratio of 1:3, for example, means the trader risks $1 to potentially make $3. It is a core component of money management and helps traders evaluate whether a trade’s potential upside justifies its downside.
Detailed Explanation
The risk reward ratio is calculated by dividing the amount a trader is willing to risk (the stop-loss distance) by the amount they aim to gain (the take-profit distance). The formula is:
Risk Reward Ratio = (Entry Price – Stop-Loss Price) ÷ (Take-Profit Price – Entry Price)
The result is typically expressed as "1:X", where X is the number of units of reward per one unit of risk. For example, a ratio of 1:2 means the trader risks 1 unit to gain 2 units. A ratio of 1:1 means equal risk and reward.
It is crucial to understand that the risk reward ratio does not measure the probability of a trade being successful. A trade with a favorable ratio (e.g., 1:3) can still lose money if the market moves against the trader. Conversely, a trade with an unfavorable ratio (e.g., 3:1) can still be profitable if it wins often enough. The ratio is a tool for structuring trades, not for predicting outcomes.
Traders typically set their stop-loss and take-profit levels based on technical analysis (support/resistance, volatility, chart patterns) rather than arbitrary numbers. The risk reward ratio then emerges from these levels. For instance, if a trader identifies a support level 20 pips below entry and a resistance level 60 pips above entry, the ratio is 1:3 (20 pips risk for 60 pips reward).
The ratio is most meaningful when combined with the win rate (percentage of winning trades). A trader with a 40% win rate but an average risk reward ratio of 1:3 can be profitable over time, while a trader with a 70% win rate but a ratio of 3:1 may still lose money. This relationship is captured by the expectancy formula:
Expectancy = (Win Rate × Average Win) – (Loss Rate × Average Loss)
For example, if a trader wins 40% of trades with an average win of $300 and loses 60% with an average loss of $100, expectancy = (0.4 × $300) – (0.6 × $100) = $120 – $60 = $60 per trade. This positive expectancy exists because the risk reward ratio (1:3) compensates for the lower win rate.
Real-World Example
Consider a trader analyzing the EUR/USD currency pair. The current price is 1.1050. The trader identifies a key support level at 1.1020 (30 pips below entry) and a resistance level at 1.1110 (60 pips above entry).
- Entry price: 1.1050
- Stop-loss: 1.1020 (risk = 30 pips)
- Take-profit: 1.1110 (reward = 60 pips)
Risk reward ratio = 30 pips ÷ 60 pips = 1:2
This means for every pip risked, the trader aims to gain 2 pips. If the trader risks $100 (e.g., by using a position size that results in a $100 loss if stopped out), the potential profit is $200.
Now, suppose the trader’s account balance is $10,000, and they follow the two-percent rule (risking no more than 2% per trade). The maximum risk allowed is $200. With a 1:2 ratio, the trader can set a position size such that the stop-loss distance of 30 pips equals $200 risk. The take-profit would then be $400. This demonstrates how the risk reward ratio interacts with position sizing and money management.
Why It Matters for Traders
The risk reward ratio is a fundamental building block of disciplined trading. It forces traders to define both their exit points (stop-loss and take-profit) before entering a trade, reducing emotional decision-making. By consistently using a favorable ratio (e.g., 1:2 or higher), traders can remain profitable even with a win rate below 50%.
However, the ratio alone is not a guarantee of success. A trader must also consider market conditions, volatility, and the reliability of their analysis. A high ratio (e.g., 1:5) may be tempting, but if the take-profit level is unrealistic, the trade may rarely hit its target. Conversely, a very low ratio (e.g., 1:1) may require an extremely high win rate to be profitable.
The ratio also helps traders avoid the common pitfall of "letting winners run" without a plan. By setting a predefined reward target, traders lock in profits systematically. At the same time, the stop-loss ensures that losses are contained, preventing a single bad trade from wiping out multiple gains.
Common Misconceptions
Misconception 1: A higher risk reward ratio is always better.
While a high ratio (e.g., 1:10) looks attractive, it often comes with a lower probability of success. If the market rarely reaches the take-profit level, the trade may lose more often than it wins. The optimal ratio depends on the trader’s strategy and market conditions.
Misconception 2: The risk reward ratio predicts the outcome of a trade.
The ratio is a structural tool, not a predictive one. It tells you what will happen if the trade hits either target, but it does not indicate which outcome is more likely. A 1:3 ratio does not mean the trade has a 75% chance of winning.
Misconception 3: You should always aim for a ratio of at least 1:2.
This is a common heuristic, but it is not a universal rule. Some strategies (e.g., scalping) may use a 1:1 ratio with a high win rate. Others (e.g., trend following) may use 1:5 or higher with a lower win rate. The key is consistency and alignment with the trader’s overall plan.
Related Terms
How XM Compares
XM, as a global forex and CFD broker, provides trading platforms where traders can set stop-loss and take-profit orders to implement their risk reward ratios. The broker offers flexible leverage and a range of account types, which can affect position sizing and risk calculations. However, the concept of the risk reward ratio itself is universal and independent of any broker. Traders should always verify current terms, spreads, and execution policies on XM’s official website, as these factors can influence the practical application of the ratio. This entry does not constitute a recommendation to trade with XM or any specific broker.
Compliance Footer
⚠️ This glossary entry is educational. Forex/CFD trading carries high risk. This is not investment advice.
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