The risk-to-reward ratio is one of the most important principles of financial and investment management. It determines whether a particular trade is worth taking, considering possible losses and expected profits. Neglecting this ratio can lead to significant financial losses, while its proper application can lead to stable capital growth.

What is the risk-to-reward ratio?

The risk-to-reward ratio is the relationship between potential loss and possible profit. For example, if you risk $100 to earn $300, your ratio is 1:3. This means that for every unit lost, you can potentially gain three.

Why is it important to adhere to?

1️⃣ Capital management

If a trader or investor consistently takes trades with a low ratio (for example, 1:1 or worse), he risks quickly exhausting his capital. Even successful trades do not compensate for losses if the probability of winning is not in his favor.

Example:

Suppose a trader has $10,000. He makes trades with a risk-to-reward ratio of 1:1 and a 50% success rate. After 100 trades, his balance is unlikely to change, as gains and losses are equal. However, if the ratio were 1:2 or 1:3, even with frequent losses, he could still remain profitable.

2️⃣ Long-term stability

Even the best investors and traders do not win in every trade. Adhering to a ratio of 1:3 or higher allows for compensation of losing trades.

Example:

An investor invests in stocks with a potential profit of 30% and acceptable losses of 10%. If three out of five trades are successful, he will be profitable even with two losing trades.

3️⃣ Psychological comfort

Following a clear risk-to-reward ratio reduces emotional stress. When an investor knows that his strategy has a positive expected value, he does not panic over temporary failures.

Example:

A trader working with a ratio of 1:3 understands that even with three consecutive losses, one successful trade can cover the losses. This prevents impulsive decisions.

✅️ How to set the ratio correctly?

▪️Analyze the market – consider volatility and growth potential.

▪️Determine entry and exit points – before a trade, one must know where to set losses and profits.

▪️Follow the strategy – avoid trades with a low ratio.