What is Risk-to-Reward Ratio?

While trading individual stocks, the risk-to-reward ratio is a metric that is used to weigh a trade’s potential profit or reward, against its potential loss or risk.

The optimal risk-to-reward ratio helps stock traders and investors to determine the price at which they plan to exit a trade, regardless of whether it generates a profit or a loss. 

Basically, it assists in calculating losses and profits and provides a reason for due deliberation before entering a trade.

Computation of the risk-to-reward ratio is done by dividing the amount an individual stands to lose if the price of an asset moves unexpectedly or the risk, by the amount of profit that an individual anticipates making when the position is closed or the reward.

If an individual witnesses a trade that looks appealing due to price formations, economic factors, or plain intuition, one can afford to take on more risk and have a risk-to-reward ratio of 1:2, 1:1, or even 1:0.5.

However, the lower the risk-to-reward ratio, the lower the chances of profiting in the trade. 

About 1:3 or 3 units of expected return for each unit of additional risk is frequently regarded as the ideal risk-to-reward ratio among market strategists.

Generally, a stop-loss order is used to exit a position if it starts to move in the opposite direction than the expectations of a trader.

In order to succeed in a trade, an individual should be able to strike a balance between the risk-to-reward ratio and the trade’s win rate.

To achieve this, one must avoid making emotional decisions as this can alter the predetermined financial goal and lead an individual to make inconsistent bets. So, to take a calculated risk, a risk-to-reward ratio is to be considered always.