The Risk/Reward Ratio is an important analytical tool used by traders and investors to assess the viability of a particular trade.
What is the Risk/Reward Ratio?
It is simply a comparison between:
Risk: The amount you could lose on the trade.
Reward: The amount you expect to gain if the trade goes in your favor.
Formula:
\text{Risk/Reward Ratio} = \frac{\text{Potential Loss}}{\text{Potential Profit}}
Example:
If you enter a trade where you could lose $100, against a potential gain of $300:
\text{R/R Ratio} = \frac{100}{300} = 1:3
What is a good ratio?
The common and preferred ratio is 1:2 or 1:3, meaning you risk one dollar for the potential to gain 2 or 3 dollars.
A ratio less than 1:1 is considered unviable in the long run, as it means losses are greater than potential gains.
Why is it important?
It helps you assess whether the trade is worth entering.
It protects your capital and keeps your trading organized and strategic.
It enhances discipline and prevents entering random trades.