Risk & volatility

Risk-reward ratio

Risk-reward ratio is the amount a trade could lose before a chosen exit relative to the amount it could gain before a chosen target, commonly expressed as 1:2.

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What it means

A planned stock trade can have a loss threshold and a profit target. Comparing the distance to each gives a simple way to describe the trade’s potential downside and upside. For example, risking US$1 per share to seek US$2 per share is often described as 1:2 risk to reward. The same relationship is 2:1 reward to risk. Because people use both conventions, always label which number represents risk.

These amounts depend on assumed entry and exit prices. A stop order may fill at a different price from its stop level, and a target may never be reached. The ratio is a planning measure, not a forecast or a measure of how likely either outcome is.

How it is calculated

For a hypothetical long stock trade with a planned entry above the loss threshold and below the target:

Risk-to-reward ratio = (entry price − loss-threshold price) / (target price − entry price)

  • Entry price: assumed purchase price, in US$ per share.
  • Loss-threshold price: planned exit level if the trade moves against the position, in US$ per share.
  • Target price: planned exit level if the trade moves favorably, in US$ per share.

Both differences must be positive. The result is dimensionless: US$ per share cancels out. To express it as 1:x, divide the potential gain per share by the potential loss per share. This gross price-based calculation excludes commissions, spread and other execution costs. An equivalent total-dollar calculation multiplies both price differences by the same number of shares, so share quantity cancels out before costs.

Worked example

Suppose, hypothetically, an investor plans to enter a long position of 100 shares at US$50, with a loss threshold of US$48 and a target of US$54.

  1. Potential price loss: US$50 − US$48 = US$2 per share, or US$200 for 100 shares.
  2. Potential price gain: US$54 − US$50 = US$4 per share, or US$400 for 100 shares.
  3. Risk divided by reward: US$2 / US$4 = 0.5, conventionally stated as 1:2 risk to reward. Reversing the order gives 2:1 reward to risk.

For a separate, purely hypothetical illustration of costs, suppose total entry and exit execution costs are US$20 under either outcome. The potential net loss becomes US$220, while the potential net gain becomes US$380. Net risk to reward is then 220:380, or approximately 1:1.73. Actual costs and fills can differ across outcomes.

Why it matters before you trade

A risk-reward ratio makes an investor’s assumptions explicit. Before placing an order, it helps distinguish a large price target from a favorable comparison of potential gain and loss after costs. It can also inform position-sizing calculations: a US$2-per-share planned loss on 100 shares is US$200, but a gap or adverse fill could make the realized loss larger.

The ratio alone does not establish that a trade has positive expected value. As a simplified illustration, a 1:2 risk-to-reward setup that wins 20% of the time would have an expected result of 0.20 × 2 − 0.80 × 1 = −0.40 units of risk per trade, before costs. The example assumes only two outcomes and does not estimate any real trade’s win probability.

How PreTrAIde uses it

The product facts do not say that PreTrAIde calculates a risk-reward ratio or uses one to determine its verdict. Its pre-trade analysis instead assesses a user-built stock basket before an order is placed. It returns GO, NO-GO or MODIFY verdicts, risk assessments, model-estimated success probabilities and suggested execution strategies, with plain-language reasoning. Its quantitative layer estimates factors including spread, market impact, volatility and one-day 95% value at risk (VaR).

Those estimates relate to assumptions behind a risk-reward calculation, particularly execution costs and downside risk, but they are not a substitute for a user-defined loss threshold and target. A PreTrAIde success probability is not a forecast of returns, and its verdicts are decision support, not recommendations.

Common mistakes

  • Reversing the convention: State whether a displayed 1:2 means risk to reward or reward to risk.
  • Ignoring execution costs: Spread, market impact and commissions can reduce potential gain or increase potential loss.
  • Treating a stop as a guaranteed fill: Gaps and limited liquidity can move the execution price beyond the planned threshold.
  • Confusing payoff size with probability: A large potential reward says nothing by itself about the chance of reaching it.
  • Using an arbitrary target: Changing a target solely to improve the displayed ratio does not change the market or make the outcome more likely.

Frequently asked questions

What does a 1:2 risk-reward ratio mean?

Under the risk-to-reward convention, it means a planned loss of one unit for a potential gain of two units. It describes assumed payoff sizes, not the probability of either outcome.

Is a higher reward-to-risk ratio always better?

No. A larger potential payoff may come with a lower chance of reaching the target, and execution costs or adverse fills can change the realized result.

Does a stop-loss guarantee the risk used in the ratio?

No. A stop price is a planned trigger, not a guaranteed execution price; a gap or thin liquidity can produce a larger loss.

Related terms

Stop-loss Stop-loss is a planned exit from a position if its price reaches a specified threshold, intended to limit losses but unable to guarantee a maximum loss or an execution price. Position sizing Position sizing is the process of deciding how many shares to hold or trade based on available capital, intended portfolio weight and the amount of risk an investor is prepared to take. Risk per trade Risk per trade is the estimated amount or percentage of account equity that could be lost on one trade if an assumed exit price is reached, excluding losses beyond that price. Transaction costs Transaction costs are the explicit fees and implicit trading costs incurred when executing a trade, including commissions, the bid-ask spread and market impact. Success probability Success probability is a model-estimated percentage attached to a pre-trade verdict, expressing the model’s assessed chance of meeting its defined success criteria, not the chance of earning a return. Pre-trade analysis Pre-trade analysis is the assessment of a proposed stock order or basket before placement, estimating execution costs, liquidity and risk to inform the investor’s decision and execution approach.

Risk & volatility

Volatility Historical volatility Implied volatility Annualized volatility Daily volatility Parkinson volatility estimator Yang-Zhang volatility estimator GARCH model All glossary terms →

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Educational content, not investment advice. PreTrAIde is analysis software, not a broker: it never executes orders, and its verdicts are decision support, not recommendations to buy or sell.