Risk/Reward Ratio

Definition of 'Risk/Reward Ratio'


A ratio used by many investors to compare the expected returns of an investment to the amount of risk undertaken to capture these returns. This ratio is calculated mathematically by dividing the amount he or she stands to lose if the price moves in the unexpected direction (i.e. the risk) by the amount of profit the trader expects to have made when the position is closed (i.e. the reward).

Investopedia explains 'Risk/Reward Ratio'


Let's say a trader purchases 100 shares of XYZ Company at $20 and places a stop-loss order at $15 to ensure that her losses will not exceed $500. Let's also assume that this trader believes that the price of XYZ will reach $30 in the next few months. In this case, the trader is willing to risk $5 per share to make an expected return of $10 per share after closing her position. Since the trader stands to make double the amount that she has risked, she would be said to have a 1:2 risk/reward ratio on that particular trade. The optimal risk/reward ratio differs widely among trading strategies. Some trial and error is usually required to determine which ratio is best for a given trading strategy.



comments powered by Disqus
Hot Definitions
  1. Effective Annual Interest Rate

    An investment's annual rate of interest when compounding occurs more often than once a year. Calculated as the following:
  2. Debit Spread

    Two options with different market prices that an investor trades on the same underlying security. The higher priced option is purchased and the lower premium option is sold - both at the same time. The higher the debit spread, the greater the initial cash outflow the investor will incur on the transaction.
  3. Odious Debt

    Money borrowed by one country from another country and then misappropriated by national rulers. A nation's debt becomes odious debt when government leaders use borrowed funds in ways that don't benefit or even oppress citizens. Some legal scholars argue that successor governments should not be held accountable for odious debt incurred by earlier regimes, but there is no consensus on how odious debt should actually be treated.
  4. Takeover

    A corporate action where an acquiring company makes a bid for an acquiree. If the target company is publicly traded, the acquiring company will make an offer for the outstanding shares.
  5. Harvest Strategy

    A strategy in which investment in a particular line of business is reduced or eliminated because the revenue brought in by additional investment would not warrant the expense. A harvest strategy is employed when a line of business is considered to be a cash cow, meaning that the brand is mature and is unlikely to grow if more investment is added.
  6. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will be executed at a specified price (or better) after a given stop price has been reached. Once the stop price is reached, the stop-limit order becomes a limit order to buy (or sell) at the limit price or better.
Trading Center