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Learn the meaning of the risk/reward ratio in trading, how it is calculated, and why it plays an important role in evaluating trades.
In trading, every decision involves a balance between potential profit and possible loss. The risk/reward ratio is a tool that helps investors measure this balance before entering a trade. It compares the amount of money that could be lost if the trade goes wrong with the amount that could be gained if it goes right. For example, risking ₹500 to potentially make ₹1,000 gives a ratio of 1:2. This ratio helps traders decide whether the potential reward justifies the risk, supporting disciplined trading.
The risk/reward ratio is a measure used in trading to compare the potential loss of a trade with the possible profit. It helps investors decide if the reward is worth the risk taken. The ratio is usually expressed in numbers like 1:2 or 1:3, where the first number represents the risk and the second shows the potential reward. For example, if a trader risks losing ₹500 but has a chance to gain ₹1,000, the risk/reward ratio is 1:2. This means for every ₹1 at risk, there is a possibility to earn ₹2.
Imagine a stock trading at ₹1,000. A trader sets a stop-loss at ₹950, which limits the maximum loss to ₹50 per share, and a target price at ₹1,100, aiming for a profit of ₹100 per share. Here, the risk is ₹50 and the reward is ₹100, making the ratio 1:2. If the trader buys 100 shares, the total risk is ₹5,000, while the potential reward is ₹10,000. This example shows how the ratio helps traders assess whether the potential gain justifies the risk.
The risk or reward ratio can be calculated using the formula:
Risk or Reward Ratio = Potential Loss ÷ Potential Gain
For example:
Current stock price: ₹1,000
Stop-loss price: ₹950 → Risk = ₹50
Target price: ₹1,100 → Reward = ₹100
Risk/Reward Ratio = ₹50 ÷ ₹100 = 1:2
This calculation means the trader risks ₹1 to potentially earn ₹2. Traders often use this ratio before entering trades to ensure that the expected reward outweighs the possible loss.
The risk/reward ratio works as a guide for traders to filter out unfavourable trades. By comparing potential losses and gains, it helps in focusing only on opportunities with enhanced returns relative to risks. For instance, a trade with a ratio of 1:1 means risking ₹100 for a reward of ₹100, which offers no advantage. On the other hand, a 1:3 ratio means risking ₹100 for the chance to earn ₹300, which is more attractive. Traders often apply this consistently across trades, ensuring that even if several positions fail, the winning trades can cover losses and generate profit overall.
Using the risk/reward ratio provides several benefits for traders:
Helps identify trades where the reward justifies the risk.
Encourages disciplined decision-making and avoids impulsive trades.
Assists in setting realistic stop-loss and target levels.
Supports long-term profitability by focusing on favourable trade setups.
For example, avoiding trades with a 1:1 ratio but accepting those with 1:3 ensures that even if several trades fail, the profitable ones can balance or exceed the losses.
The risk/reward ratio is important because it allows traders to manage risk effectively and maintain control over their strategies. Without this measure, investors might enter trades where the possible loss is greater than the potential gain, leading to poor outcomes. For instance, risking ₹2,000 for a reward of only ₹1,000 creates a 2:1 ratio, which is unfavourable. On the other hand, targeting a reward of ₹4,000 while risking ₹1,000 creates a 1:4 ratio, which is much more sustainable. This makes the ratio a crucial element of disciplined trading.
There is no universal risk/reward ratio, as it depends on trading style and tolerance for risk. However, many traders prefer a ratio of at least 1:2 or 1:3. For example, if a trader risks ₹500 on a trade, a 1:2 ratio means aiming for a profit of ₹1,000, while a 1:3 ratio means targeting ₹1,500. These ratios ensure that even with a success rate of less than 50%, traders can still remain profitable over time. By choosing higher reward-to-risk setups, traders build a cushion against potential losses.
The risk/reward ratio shows the relationship between the potential profit and the possible loss of an investment or trade. It helps assess how much risk is being taken for the expected level of return, indicating whether the potential reward justifies the risk involved.
The ratio is based on estimated entry, exit, and stop-loss levels, which may not always reflect real market conditions. It also doesn’t factor in elements like volatility, probability of success, or sudden price movements, making it an incomplete measure when used alone.
The risk/reward ratio is a valuable tool for evaluating trades by comparing potential losses with possible gains. It helps traders stay disciplined, manage risks, and focus on opportunities where rewards outweigh risks. For example, a ratio of 1:3 ensures that the reward is three times higher than the risk, helping traders make consistent, informed decisions over time.
This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.
In options trading, the ratio helps compare the premium paid (risk) with the potential profit from price movements (reward).
It shows how much a trader risks versus the potential gain, such as 1:3 meaning risking ₹1 for the chance to earn ₹3.
It means the potential reward is 1.5 times greater than the risk. For example, risking ₹200 for a possible profit of ₹300 gives a 1:1.5 ratio.
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