Risk reward ratio

Risk Reward Ratio: Definition, Formula, Example, and FAQs

The risk reward ratio is a crucial financial metric used to compare the potential gains of an investment against its potential losses. It falls under the broader category of Investment Analysis and is a foundational concept in portfolio management. By quantifying the relationship between what an investor stands to lose and what they aim to gain, the risk reward ratio provides a clear numerical perspective to aid in investment decision making.⁴¹ This ratio helps market participants, from individual investors to large institutions, assess whether a particular trade or investment opportunity aligns with their risk tolerance.

History and Origin

The concept of evaluating potential return against potential risk has always been central to financial endeavors. However, the formalization of this relationship began to take shape with the advent of modern portfolio theory. Harry Markowitz, awarded the Nobel Memorial Prize in Economic Sciences in 1990, is widely credited for his pioneering work in the 1950s that provided a rigorous framework for portfolio selection.⁴⁰ Markowitz's work fundamentally established financial micro-analysis as a respectable research area, focusing on how wealth could be optimally invested in assets differing in their expected return and risk, thereby also demonstrating how risks could be reduced through diversification.³⁸, ³⁹ While not explicitly defining the "risk reward ratio" by name, his mathematical approach to the risk-return trade-off laid the theoretical groundwork for such quantitative measures, which became indispensable tools for traders and investors seeking to balance these two critical elements.³⁷

Key Takeaways

• The risk reward ratio compares an investment's potential loss to its potential return.³⁶
• It is a key tool in risk assessment and helps investors decide if a trade is worthwhile.³⁵
• A lower ratio (e.g., 1:3) is generally more favorable, indicating that the potential reward significantly outweighs the potential risk.³⁴
• The ratio requires clearly defined stop-loss order and take-profit target levels.³³
• While valuable, the risk reward ratio has limitations as it relies on estimates and does not account for market volatility or changes in sentiment.³²

Formula and Calculation

The risk reward ratio is calculated by dividing the potential loss by the potential gain for a specific investment or trade.³¹

To determine these values, traders typically define:

• Potential Loss: The difference between the entry price and the stop-loss order price.³⁰ This represents the maximum amount of capital an investor is willing to lose if the trade moves unfavorably.²⁹
• Potential Gain: The difference between the take-profit target price and the entry price.²⁸ This represents the anticipated profit if the trade goes as planned.²⁷

For example, if an investor buys a stock at $50, sets a stop-loss at $45 (potential loss of $5), and a take-profit target at $65 (potential gain of $15), the calculation would be:

This means for every $1 risked, there is a potential to gain $3.²⁶

Interpreting the Risk Reward Ratio

The interpretation of the risk reward ratio is straightforward: a lower ratio is generally more attractive. For instance, a ratio of 1:3 suggests that for every unit of risk taken, an investor expects to gain three units of reward.²⁵ This indicates a favorable setup, as the potential profit significantly outweighs the potential loss. Conversely, a ratio of 1:1 implies that the potential gain is equal to the potential loss, which many experienced traders consider less desirable, often equating it to a gamble unless the probability of success is exceptionally high.²⁴

Professional traders and investors often seek trades with risk reward ratios of 1:2 or higher (meaning the potential reward is at least twice the potential risk) to ensure that even with a win rate below 50%, their overall trading strategy can remain profitable.²³ This numerical guide helps to bring discipline to investment strategy, moving away from purely emotional decisions.²¹, ²²

Hypothetical Example

Consider an investor analyzing shares of Company ABC. The current share price is $100. The investor believes that due to upcoming positive news, the stock could rise to $130, representing a potential gain of $30 per share. To manage downside risk, the investor decides to place a stop-loss order at $90 per share, meaning a potential loss of $10.

1. Calculate Potential Loss: Entry Price ($100) - Stop-Loss Price ($90) = $10
2. Calculate Potential Gain: Take-Profit Target ($130) - Entry Price ($100) = $30
3. Calculate Risk Reward Ratio: Potential Loss ($10) / Potential Gain ($30) = 1/3

In this scenario, the risk reward ratio is 1:3. This indicates that for every $1 the investor risks, they stand to gain $3 if the trade is successful. This is generally considered a favorable ratio, suggesting that the potential reward is substantial relative to the risk assumed.

Practical Applications

The risk reward ratio is widely applied across various facets of finance to help manage exposures and inform investment decision making.

• Individual Trading and Investing: Day traders and swing traders frequently use the risk reward ratio to evaluate short-term opportunities, ensuring that each trade aligns with their predefined risk parameters. Long-term investors may also use it for significant capital allocation decisions, albeit with broader price targets and stop-loss considerations.²⁰
• Portfolio Construction: While the ratio is often applied to individual assets, its underlying principle of balancing risk and return influences broader asset allocation and diversification strategies. Investors aiming for higher overall portfolio returns might strategically incorporate some higher risk-reward opportunities while balancing them with lower-risk assets.
• Risk Management Systems: Financial institutions integrate risk reward principles into their formal risk management systems. This helps them control exposure to individual positions and overall market fluctuations.
• Capital Allocation: By consistently applying a favorable risk reward ratio, investors aim to preserve capital and grow wealth over time, even if not every trade is profitable.¹⁹ In dynamic markets, investors may flock to riskier assets when chasing higher returns, underscoring the constant interplay between risk and reward.¹⁸ Effective management of this balance is a cornerstone of prudent investing, emphasizing that sound investment strategy goes beyond just seeking profits.¹⁷ The Bogleheads investment philosophy, for instance, advocates for a balanced approach to risk, emphasizing long-term strategies and diversification.¹⁶

Limitations and Criticisms

While a valuable tool, the risk reward ratio is not without limitations. A primary criticism is its reliance on subjective estimates for potential loss (stop-loss) and potential gain (take-profit).¹⁵ These levels are often based on predictions or technical analysis, which are not guaranteed to be accurate. If these estimates are flawed, the calculated ratio may not provide a reliable picture of the actual risk-return dynamics.¹⁴

Furthermore, the ratio does not account for the probability of a trade's success. An investment might have an attractive 1:5 risk reward ratio, but if the likelihood of reaching the take-profit target is very low, the favorable ratio alone can be misleading.¹³ It also does not inherently reflect market volatility or sudden shifts in sentiment, which can invalidate predefined levels before an investor has a chance to react.¹² The unpredictability of markets means that even well-researched predictions can often be wrong, highlighting the inherent challenges in forecasting future returns and risks.¹¹ Moreover, setting overly tight stop-losses to achieve a seemingly better ratio can lead to premature exits from otherwise profitable positions due to normal market fluctuations. Investors must consider these factors and integrate the risk reward ratio with other analytical tools and a comprehensive risk assessment framework.¹⁰

Risk Reward Ratio vs. Sharpe Ratio

The risk reward ratio is often confused with the Sharpe ratio, but they serve different purposes in investment analysis.

While the risk reward ratio provides a direct comparison of specific monetary outcomes, the Sharpe ratio offers a more holistic view of an investment's efficiency by penalizing higher volatility.⁵, ⁶ An investment might have an appealing risk reward ratio, but if it achieves that ratio with excessive price swings, its Sharpe ratio might be low, suggesting it's not efficiently compensating for the overall risk taken. Both ratios are valuable, but they offer different perspectives on the intricate relationship between risk and return.

FAQs

Q: What is a good risk reward ratio?
A: A commonly sought risk reward ratio is 1:2 or 1:3, meaning you are risking $1 to potentially gain $2 or $3.³, ⁴ However, what constitutes a "good" ratio can vary depending on an individual's risk tolerance and the specific investment strategy being employed.

Q: Can the risk reward ratio guarantee profits?
A: No, the risk reward ratio does not guarantee profits. It is a tool for managing potential outcomes, not predicting them.² It helps structure trades to ensure that when wins occur, they are large enough to offset potential losses, but it provides no indication of the probability of success.¹

Q: How does the risk reward ratio relate to position sizing?
A: The risk reward ratio is closely linked to position sizing. Once an investor determines an acceptable risk reward ratio for a trade, they can use it, along with their total available capital and defined stop-loss, to calculate how many shares or units of an asset they can afford to trade while keeping the overall risk within their comfort level.