The risk reward ratio compares what you stand to lose on a trade against what you stand to gain. You calculate it by dividing your potential loss by your potential profit. If you risk $100 to make $300, the ratio is 1:3. That means for every dollar you risk, you expect to gain three dollars back.
A ratio of 1:2 or higher is common among experienced traders. Anything below 1:1 means you need a very high win rate just to break even. But the ratio alone does not tell you if a trade is good. You also need to know the probability of it working out.
The formula
Risk reward ratio = (Entry price minus stop loss) divided by (Take profit minus entry price).
For a long trade: risk is entry minus stop loss. Reward is take profit minus entry. For a short trade, reverse the subtraction.
Example. You buy a stock at $50. You set a stop loss at $48. You set a take profit at $56. Risk is $2 per share. Reward is $6 per share. Ratio is 2 divided by 6, or 1:3.
Why beginners get it wrong
Many traders calculate the ratio based on the full distance they hope the price will move. But the real risk is the distance from entry to stop loss, not from entry to zero. If you buy at $50 and set no stop loss, your risk is technically the full $50. That is not a trade. That is a gamble.
Another mistake is ignoring slippage and spreads. In fast markets or with leveraged products like CFDs or crypto perpetuals, the stop loss may fill at a worse price than expected. A $2 risk can become $2.50 or $3. That changes the ratio. Always add a small buffer to your stop distance to account for this.
Worked scenario
You trade Bitcoin perpetuals on a margin of 10x. Entry at $60,000. Stop at $58,500. Take profit at $66,000.
Risk is $1,500 per Bitcoin. Reward is $6,000 per Bitcoin. Ratio is 1,500 divided by 6,000, or 1:4.
But with 10x leverage, your actual capital at risk is 10 percent of the position size, not the full $1,500 per coin. If you control 1 Bitcoin with $6,000 margin, a $1,500 loss is 25 percent of your margin. The ratio calculation stays the same because it is based on the price move, not the margin percentage. But the impact on your account is larger than the ratio suggests. Leverage magnifies both risk and reward proportionally.
A practical checklist before entering
First, identify the stop loss level based on technical structure, not on the ratio you want. A stop should sit below a support level or above a resistance level, not at a round number you picked for convenience.
Second, calculate the distance from entry to stop in price terms.
Third, find a take profit level that gives you at least twice that distance. If the market structure only offers a 1:1 ratio, skip the trade.
Fourth, check if the ratio changes after accounting for fees, slippage, and spread. If the adjusted ratio drops below 1:1.5, reconsider.
Fifth, ask yourself what percentage of your account you are risking. A 1:3 ratio means nothing if you risk 20 percent of your capital on one trade. The ratio and position size work together.
Risk context
No ratio guarantees profit. A 1:10 ratio fails if the trade goes against you before hitting the target. The stop loss must be respected. Moving the stop wider after entry to avoid a loss turns a planned risk into an unplanned one.
For short selling and CFD trading, the risk is theoretically unlimited if no stop is used. A stock can rise far above your short entry. The ratio calculation assumes a fixed stop. Without it, the ratio is meaningless.
For crypto and leveraged products, funding rates and overnight fees can eat into the reward side. A trade that looks like 1:3 on entry may become 1:2 after three days of negative funding. Factor in holding costs.
One more example
You trade EUR/USD with a broker that charges a 1 pip spread. Entry at 1.1000. Stop at 1.0980. Take profit at 1.1040.
Risk is 20 pips plus 1 pip spread, so 21 pips. Reward is 40 pips minus 1 pip spread, so 39 pips. Ratio is 21 divided by 39, roughly 1:1.86. Without the spread, the ratio would be 1:2. The spread shaved off 7 percent of the reward. That matters over many trades.
Final note
The risk reward ratio is a planning tool, not a performance metric. It tells you what you expect before the trade starts. After the trade closes, the only numbers that matter are the actual loss or gain. Use the ratio to filter out bad setups, not to justify holding a losing position because the target is still far away.
Prepared with AlphaScala editorial tooling, examples, and risk-context checks against our education standards. General education only, not personalized financial advice.