Understanding the Risk Return Ratio: A Trader's Essential Tool

The Core Principle Behind Smart Trading Decisions

Every profitable trader knows one thing: not all trades are created equal. Some opportunities promise massive gains but demand enormous risk, while others deliver steady profits with minimal downside exposure. The difference? Understanding your risk return ratio.

The risk return ratio—often called the risk/reward ratio—is fundamentally about comparing your potential losses against your potential gains on any given trade. It answers a deceptively simple question: For every dollar you risk, how many dollars can you potentially make?

Surprisingly, many active traders overlook this calculation entirely. Yet it’s one of the most powerful tools for separating consistent winners from account-blowers. Let’s dig into why this matters and how to use it.

A Story That Illustrates the Point

Imagine standing at a crossroads with two bets on the table:

Bet One: Sneak into the birdhouse at the zoo and hand-feed a parrot. Your reward? 1 Bitcoin. The risk? Getting caught by security.

Bet Two: Enter the tiger cage and feed raw meat to a tiger with your bare hands. Your reward? 1.1 Bitcoin (slightly more). The risk? Potential serious injury or worse—plus getting caught.

Which deal makes sense? Even though Bet Two offers a little more reward, you’re exponentially increasing your downside for a marginal gain. This is the essence of poor risk return management.

Most professional traders reject bets like this. Instead, they hunt for asymmetric opportunities—setups where the potential upside dramatically exceeds the potential downside. This is how fortunes are built in markets.

How to Calculate Your Risk Return Ratio

Let’s move from theory to numbers. Here’s the practical process:

Step 1: Determine Your Entry Point You’ve analyzed the market and decided Bitcoin looks attractive. You’re ready to enter a long position at your chosen price level.

Step 2: Set Your Profit Target Based on your technical analysis, you determine that if the trade works out, you’ll exit with a 15% gain from your entry price.

Step 3: Place Your Stop-Loss This is critical. Where does your thesis break down? Where will you admit you were wrong and exit? You decide that if Bitcoin falls 5% from your entry, the trade setup is invalidated. That’s your stop-loss.

Step 4: Do the Math The calculation is straightforward:

Risk Return Ratio = Potential Loss ÷ Potential Profit

In this case: 5% ÷ 15% = 1:3 (or 0.33 as a decimal)

This means for every unit of risk you’re taking, you’re positioned to earn three units of reward. In dollar terms: risk $5 to potentially make $15 on a $100 position.

Important note: These profit and stop-loss levels should never be arbitrary. They must emerge from your technical analysis, chart patterns, and support/resistance levels. Gaming the numbers by moving stops closer to entry might improve the ratio on paper, but it weakens your trade thesis.

The Inverse Approach: Reward/Risk Ratio

Some traders flip this calculation around, computing the reward/risk ratio instead—essentially dividing profit by risk rather than risk by profit.

Using our Bitcoin example: 15% ÷ 5% = 3

With this approach, a higher number is better (the opposite logic of risk/reward). It’s purely a preference thing. Both methods convey the same information; the reward/risk ratio just feels more intuitive to some traders who prefer seeing their potential wins first.

Why Position Size Doesn’t Change the Ratio

An important insight: the risk return ratio remains consistent regardless of your position size.

Take our Bitcoin trade:

• Position 1: $100 position → Risk $5, gain $15 → Ratio is 1:3
• Position 2: $10,000 position → Risk $500, gain $1,500 → Ratio is still 1:3

The ratio only shifts when you change the relative distance between your entry, profit target, and stop-loss. Position size is irrelevant to the calculation itself—though it dramatically matters for your portfolio risk management.

Combining Risk Return Ratio With Win Rate

Here’s where it gets powerful. Your win rate (percentage of profitable trades) combined with your risk return ratio determines your long-term profitability.

Scenario: An options trader risks $100 per trade seeking $700 in profit (1:7 risk return ratio). However, these particular options only win 20% of the time. Does this work?

Let’s run 10 trades:

• Total capital deployed: $1,000
• Expected wins: 2 trades (20% of 10)
• Profit from wins: 2 × $700 = $1,400
• Net result: +$400 profit

But what if each winning trade only returned $500?

• Profit from wins: 2 × $500 = $1,000
• Net result: Break-even

With a 20% win rate, that trader would need at least a 1:5 risk return ratio just to break even. This shows how win rate and risk return ratio must work together.

The Real Edge: Low Win Rate + Excellent Risk Return Ratio

Here’s the counterintuitive truth: a trader with a 20% win rate can be highly profitable if their risk return ratios are exceptional.

Example: If every trade targets a 1:10 risk return ratio:

• Win 1 trade, lose 9 trades
• Net result: Break-even
• Win 2 trades, lose 8 trades
• Net result: 100% profit on capital

This is why professional traders obsess over finding high-quality setups. It’s not about winning most of the time—it’s about winning enough when your odds are stacked in your favor.

Building This Into Your Trading Plan

Calculating your risk return ratio should be non-negotiable before entering any trade. Here’s why:

1. Validates Your Trade Setup: If you can’t get a favorable ratio, the setup probably isn’t worth taking.

2. Removes Emotion: Clear pre-calculated targets eliminate the temptation to hope or panic.

3. Enables Scaling: Understanding your risk return ratios lets you size positions appropriately.

4. Reveals Patterns: Keeping a trading journal of your risk return ratios shows which setups actually work for you.

Different market conditions and asset classes produce different average risk return ratios. By tracking this data, you adapt your strategy accordingly.

Final Thoughts

The risk return ratio isn’t just a number to calculate—it’s a lens through which professionals view every opportunity. By hunting for trades where potential rewards significantly exceed potential risks, and combining that insight with your historical win rate, you create a mathematical advantage.

Most traders fail because they take random risks without analyzing the payoff structure. Those who succeed have internalized this principle: Make every risk count by ensuring the potential reward justifies it. That’s how consistent profitability emerges over time.