Risk Reward Ratio: Formula, Example and Limits

What is the risk reward ratio?

Using the reward-to-risk convention, the risk reward ratio is potential reward divided by potential risk. The formula is: reward-to-risk ratio = potential reward ÷ potential risk. A result of 3 means the planned reward is three times the planned risk, usually written as 3:1.

The name can cause confusion because some platforms and traders calculate risk divided by reward instead. Under that inverse convention, the same plan is shown as 1:3 or 0.33. Neither display changes the trade. The important step is to label the calculation as reward-to-risk or risk-to-reward before comparing it with another number.

Potential risk is the distance from the planned entry to the planned stop, multiplied by position size when the ratio is calculated in money. Potential reward is the distance from the entry to the target, also multiplied by position size. When the same size applies to both sides, using price distance gives the same ratio.

Risk reward ratio example

Suppose a planned long trade has an entry at $50, a stop at $48 and a target at $56. The risk per share is $2: $50 minus $48. The potential reward per share is $6: $56 minus $50. Using reward divided by risk, $6 ÷ $2 = 3, so the planned reward-to-risk ratio is 3:1.

For 100 shares, the planned price risk is $200 and the planned reward is $600 before commissions, fees, spread and slippage. Dividing $600 by $200 still gives 3:1. Position size changes the dollar amount at stake, but it does not change the ratio when size is constant throughout the plan.

Costs and slippage change the real payoff

The clean 3:1 example is a price-distance calculation. Commissions, regulatory fees, bid-ask spread and other trading costs reduce the amount kept from a winner and add to the total cost of a loser. Frequent trading or small targets can make these differences material even when each charge looks small.

Slippage is the difference between an expected price and the price actually received. A stop order may fill below $48 in a fast market, so the loss can exceed the planned $2 per share. A target order may also fill differently, and gaps can make the difference larger. A stop is part of a plan, not a guarantee of the final loss amount.

For review, calculate the planned ratio from the stated entry, stop and target. Then record actual fills and all known costs separately. This lets you compare the plan with the net result without pretending they are the same measurement.

A higher ratio does not prove a better trade

A ratio says nothing by itself about the probability of reaching the target before the stop. Moving a target farther away makes the displayed reward larger, but it may also make the target less likely to be reached. Likewise, placing a stop very close to entry can make the ratio look attractive while increasing the chance that ordinary price movement reaches it.

Win rate supplies another part of the picture. Ignoring costs, a 3:1 reward-to-risk plan has a mathematical break-even win rate of 25 percent: one 3R win offsets three 1R losses. Costs and slippage raise the win rate needed to break even. Actual wins and losses may also differ from the planned target and stop, so the planned ratio should not be used as though every outcome were exactly +3R or -1R.

For example, if comparable trades win 20 percent of the time and each winner earns 3R while each loser loses 1R, the average is negative before costs: (0.20 × 3R) minus (0.80 × 1R) = -0.20R per trade. This is only arithmetic, not a forecast. A small or selectively chosen sample may not represent what happens next.

Use the ratio with a comparable trade sample

Ask whether a clearly defined setup produced a workable combination of realized payoff, win rate and costs across a meaningful sample. Compare similar conditions and rules where possible. Include stopped trades, early exits, partial fills and rule breaks, then tag them for separate review. The ratio describes a plan, while the journal shows how that plan met actual execution.

Risk reward ratio journal checklist

Use a short, consistent entry for each planned trade. The aim is to preserve the inputs and the outcome, not to turn the ratio into a pass or fail score.

1. Label the convention: reward-to-risk or risk-to-reward.
2. Record planned entry, stop, target and position size before the trade.
3. Calculate price risk, potential reward and the planned ratio.
4. Record actual fills, partial exits, fees and other known costs.
5. Compare planned and realized R without moving the original reference points.
6. Review win rate, average win, average loss and trade count for comparable setups.

What the ratio can and cannot tell you

Risk reward ratio is a compact description of the payoff built into a trade plan. It can help make an entry, stop and target internally consistent, and it gives a journal a common unit for comparing planned outcomes.

It cannot show whether the target is realistic, estimate the chance of winning, guarantee a stop price, include costs automatically or establish that a strategy has an edge. Use it as one recorded input alongside actual fills, net results, win rate and the size and quality of the sample. It is a planning and review measure, not financial advice or a prediction.