Risk-reward ratio

Two things decide whether a trading approach adds up over time: how often it produces a profit, and how large those profits are next to the losses. The risk-reward ratio captures the second one. It compares what a trade could gain against what it could lose, and it explains why being right on most of your trades is not the same as finishing ahead.

What the ratio measures

The risk-reward ratio compares the amount a trade puts at stake against the profit it is aiming for. By convention the ratio is written risk first. Suppose, as an illustration, a trade risks 1 unit to aim for 2 units of profit: that is written 1:2, meaning one unit at stake for two units of potential gain. The ratio describes the shape of the payoff, not how likely either outcome is.

Win rate and the ratio together

Win rate is the proportion of trades that end in profit. A high win rate can still lose money if the occasional losses are far larger than the frequent wins, and a lower win rate can finish ahead if each win is large next to each loss. To see this, suppose an approach risks 1 unit to aim for 2 units, and over 10 illustrative trades it wins 4 and loses 6. The four wins add 8 units and the six losses remove 6 units, leaving a net gain of 2 units despite winning fewer than half the trades.

• At 1:1, where the reward equals the risk, an approach needs to win about half of its trades just to break even.
• At 1:2, where the reward is twice the risk, the breakeven win rate falls to roughly 33 percent.
• At 1:3, where the reward is three times the risk, the breakeven win rate falls to roughly 25 percent.

The pattern is that a larger reward relative to the risk lowers the win rate an approach needs simply to break even. That is why a method can be wrong more often than it is right and still, across many trades, finish level or ahead. It also works in reverse: when the reward is small next to the risk, a very high win rate is needed just to avoid falling behind.