Mastering the risk/reward ratio: A practical guide for successful trading

TL;DR Your ability to balance risk against reward determines long-term gains. Skilled traders do not just seek high returns – they seek high returns with limited risk. By understanding and applying the risk/reward ratio, you can set rational starting points before each trade and effectively protect your capital.

Why the risk/reward ratio is your secret weapon

Whether you are a beginner or an experienced trader, it is a fact: without a clear strategy for measuring risk against potential reward, you will lose money. It’s not about when, but about when a lot.

This is the starting point for all successful traders. They do not make impulsive decisions. Instead, they carefully plan each position – they determine exactly where they will exit a winning trade and where they need to set their stop-loss to limit losses.

Many traders focus on risk management and position sizing, which are important. But there is something that is often overlooked: the comparison between what you risk and what you can potentially earn. This ratio can be the difference between a profitable trading strategy and a way to slowly drain your account.

What exactly measures the risk/reward ratio?

The risk/reward ratio ( R/R ratio or simply “R” ) shows how much potential profit you can get for each unit of risk you take. The formula is simple, but the application is powerful.

You divide your maximum possible loss by your target profit:

Risk/reward ratio = Potential loss ÷ Potential gain

Let's say you are planning a long position in bitcoin. You analyze the market and determine two critical price levels:

• Your profit order: 15% above your entry
• Your stop loss: 5% below your entry

Then your risk/reward ratio is 5 ÷ 15 = 0.33, or expressed as 1:3.

This means that you risk 1 krona to potentially earn 3 kronor. If your position is worth 1,000 kronor, you risk 50 kronor for a possible gain of 150 kronor. It is an asymmetric opportunity where the downside is less than the upside.

How to choose your entry and exit levels

Here is the critical point: your profit targets and stop-loss should never be based on random numbers. They must be based on actual market analysis.

Use technical indicators to identify natural resistance and support levels. Observe trend lines, moving averages, and volume patterns. This provides you with scientific entry and exit points.

Only after this analysis do you calculate the risk/reward ratio. If the ratio is poor – say 1:1 or worse – it is often better to simply wait for a better trading setup than to force a weak trade by adjusting the numbers.

Reverse calculation: reward/risk ratio

Many traders prefer to work with the reward/risk ratio instead, which is the same calculation in reverse:

Reward/risk ratio = Potential gain ÷ Potential loss

In the Bitcoin example above, it would be 15 ÷ 5 = 3.

Here the principle is the opposite: the higher the reward/risk ratio, the better. A ratio of 3 or higher is generally considered attractive.

Which version you use doesn't matter – it's just a matter of personal preference.

Real Illustration: Risk versus Reward

Imagine two scenarios at a zoo:

Scenario 1: I offer you 1 bitcoin if you sneak into the birdhouse and feed a parrot. The risk? You might get caught by the staff.

Scenario 2: I offer you 1.1 bitcoin if you sneak into the tiger enclosure and feed raw meat to a tiger. The risk here is much greater – you could actually be seriously harmed.

For a margin increase of 0.1 bitcoin, you expose yourself to exponentially greater risk. It's a bad deal.

The same principle applies to trading. Many experienced traders seek agreements where they can earn 3-5 times more than they risk. They love asymmetric opportunities. They simply do not accept taking a large risk for a small reward.

Position size does not change the ratio

An important point: position size does not affect your risk/reward ratio – only the actual kronor you are risking.

If you trade a 100,000 kronor position with the same 5% stop and 15% profit target, you still get a 1:3 ratio. You risk 5,000 kronor for a 15,000 kronor profit. The ratio remains the same.

The relationship only changes if you adjust the relative position of your price levels – not the size of your positions.

Combine the risk/reward ratio with the win rate

Now it gets interesting. A high risk/reward ratio is only half the equation. You also need to consider how often you actually win trades.

Your win rate is the number of profitable trades divided by the total number of trades. If you win 60% of your trades, your win rate is 60%.

Here is the powerful insight: a trader with a low win rate can still be very profitable if her risk/reward ratio is excellent.

Example: An options trader risks 1,000 kronor to earn 7,000 kronor per trade (1:7 ratio). However, her win rate is only 20%. If she completes ten trades:

• Expenses: 10 × 1,000 = 10,000 kronor
• Winnings: 2 × 7,000 = 14,000 kronor
• Net: +4,000 kronor

She delivers 80% of the trades but is still profitable! With just a 1:5 ratio and a 20% win rate, she would only break even.

This shows why the risk/reward balance is so critical for long-term profitability.

Practical application in your trading strategy

Here is how to use this step by step:

1. Analyze the market and identify natural resistance and support levels
2. Determine your entry point based on this analysis
3. Set your profit target at a resistance level or based on a technical target
4. Place your stop at a logical position below the entry
5. Calculate the ratio before you fill a single order
6. Only accept trades with at least a 1:2 or preferably a 1:3 ratio
7. Track your trades in a trading journal to see your actual results over time

By documenting each trade, you can later analyze patterns: which settings work, which markets you prefer, and which time frames yield the best results. Your trading journal becomes your tool for continuous improvement.

Concluding Thoughts

The risk/reward ratio is not just a mathematical exercise – it is the foundation of a disciplined trading plan. It forces you to think rationally before acting and protects you from emotional decisions.

A trader who only succeeds in two out of ten trades can still be profitable if her risk/reward ratio is strong enough. Conversely, a trader who succeeds 70% of the time can lose money if she risks too much on each trade.

This balance between risk and reward – combined with your personal win rate – ultimately determines whether you build or deplete your trading account. Therefore, start today: before your next trade, calculate your risk/reward ratio. Make it a habit, and long-term success will become much more likely.