Core Definition of Risk-Reward Ratio
Risk-Reward Ratio (RR) is the ratio of potential return to potential risk for each trade.
Formula:
RR = (Target Price - Entry Price) / (Entry Price - Stop-Loss Price)
Example:
- Entry Price: $100
- Stop-Loss: $95 (Risk $5)
- Target: $115 (Reward $15)
- RR = $15 / $5 = 3:1
Why Is 1:3 the Minimum Standard?
Win Rate and Profit/Loss Ratio Relationship
| Win Rate | Minimum P/L Ratio Needed | Long-Term Result |
|---|---|---|
| 35% | 2:1 | Slight loss |
| 35% | 3:1 | Profitable |
| 40% | 2:1 | Profitable |
| 50% | 1:1 | Break even |
| 50% | 2:1 | Big profit |
Core formula:
Expectancy = (Win Rate x Average Win) - (Loss Rate x Average Loss)
Example: Win Rate 40%, RR = 3:1 Expectancy = (40% x $300) - (60% x $100) = $120 - $60 = +$60
Even with only 40% win rate, sticking to 1:3 RR yields positive long-term expectancy!
How to Set Target and Stop-Loss Prices?
Target Price Methods
- Previous High Method: Use prior highs as targets
- Pattern Calculation: Use pattern height (e.g., Double Bottom Target)
- Trailing Stop Method: No fixed target, use trailing stop-loss
Stop-Loss Methods
- Pattern Low: e.g., Cup and Handle Handle Low
- ATR Method: 2 x ATR (see ATR Guide)
- Fixed Percentage: 5-8% below entry
Practical Application
Pre-Entry Checklist
Ask yourself before every trade:
- Where is my target and stop-loss?
- Does the RR meet 1:3?
- Can I afford this loss?
If RR is below 1:3, decisively skip this trade. There is always a better opportunity. Strategy Center strategies have built-in automatic stop-loss to protect your RR.
Common Mistakes
- Mistake 1: Adjusting targets to make RR look good -- targets must have technical basis
- Mistake 2: Stop-loss too tight (< 3%) -- easily triggered by normal volatility
- Mistake 3: Entering without calculating RR -- trading on gut feel
Summary
Key numbers for risk-reward ratio:
- Minimum Standard: 1:3
- 40% Win Rate + RR 1:3 = Long-Term Profit
- 50% Win Rate + RR 1:2 = Stable Profit
Combine with Position Sizing and Diversification to build a complete risk management system. See Drawdown Management Strategy for more risk control strategies, or visit the Tutorial Center for more risk management techniques.