# 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.

## 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.

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Source: https://pretraide.com/glossary/risk-reward-ratio