What is risk/reward ratio in trading?
In one paragraph
Risk/reward ratio compares the potential loss on a trade to its potential gain — a 1:3 ratio means risking $1 to make $3.
What this actually means
Risk/reward ratio is one of the foundational concepts in trade management, expressing how much a trader stands to lose relative to how much they stand to gain on any given position. A trade with a 1:2 risk/reward ratio risks one unit of capital to target two units of profit. A 1:3 ratio risks one to target three.
The ratio matters because it directly determines how often a trader needs to be right to remain profitable. A system with a 1:2 risk/reward ratio can be profitable even if only 40% of trades are winners — the gains on successful trades outweigh the losses on the majority that fail. This is a key insight that counteracts the beginner's instinct to focus exclusively on win rate.
In practice, the ratio is calculated before entering a trade. The risk is defined by the distance between the entry price and the stop-loss level. The reward is defined by the distance between the entry and the price target. Disciplined traders only take trades where the reward is at least twice the risk — often setting a minimum threshold of 1:2 or 1:3 before committing capital.
This pre-trade calculation forces clarity. When traders skip the step and enter positions based on intuition alone, they often discover after the fact that they risked far more than they stood to gain — a structural disadvantage that erodes capital even with a decent win rate.
Risk/reward also interacts with position sizing. Knowing the maximum dollar amount to risk on any trade (commonly 1-2% of account equity) allows traders to back-calculate the appropriate number of shares or contracts based on the stop distance.
The concept appears throughout professional trading literature as a non-negotiable planning step — not a suggestion but a prerequisite to entering any position with a defined edge.