Understanding the Risk/Reward Ratio: A Guide for Stock Investors

What Is the Risk/Reward Ratio?

The risk/reward ratio, also known as the risk/return ratio, enables investors to evaluate potential returns against risks when deciding on investments. This critical tool helps determine the attractiveness of investment opportunities by comparing the dollar amount at stake with the anticipated profit.

Understanding the Mechanics of the Risk/Reward Ratio

In many cases, market strategists find the ideal risk/reward ratio for their investments to be approximately 1:3, or three units of expected return for every one unit of additional risk. Investors can manage risk/reward better using stop-loss orders and put options.

The risk/reward ratio is often used as a measure when trading individual stocks. The best risk/reward ratio varies across trading strategies. Some trial-and-error methods are usually required to determine which ratio is best for a given trading strategy, and many investors have a pre-specified risk/reward ratio for their investments.

Note that the risk/return ratio can be computed as one's personal risk tolerance on an investment, or as the objective calculation of an investment's risk/return profile. In the latter case, expected return is often used in the denominator and potential loss in the numerator. Expected return can be computed in several ways, including projecting historical returns into the future, estimating the weighted probabilities of future outcomes, or using a model like the capital asset pricing model (CAPM).

To estimate the potential loss, investors may use a variety of methods, such as analyzing historical price data with technical analysis, using the historical standard deviation of price action, assessing company financial statements with fundamental analysis, and models like value-at-risk (VaR). These methods can help investors identify factors that could impact the investment's value and estimate the potential downside.

Interpreting the Risk/Reward Ratio

The risk/reward ratio helps investors manage their risk of losing money on trades. Traders can lose money over time if their win rate is under 50%, even with some profitable trades.. The risk/reward ratio measures the difference between a trade entry point to a stop-loss and a sell or take-profit order. Comparing these two provides the ratio of profit to loss, or reward to risk.

Investors often use stop-loss orders when trading individual stocks to help minimize losses and directly manage their investments with a risk/reward focus. A stop-loss order is a trading trigger placed on a stock that automates the selling of the stock from a portfolio if the stock reaches a specified low. Investors can automatically set stop-loss orders through brokerage accounts and typically do not require exorbitant additional trading costs.

Example of the Risk/Reward Ratio

Consider this example: A trader purchases 100 shares of XYZ Company at $20 and places a stop-loss order at $15 to ensure that losses will not exceed $500. 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 the position. Since the trader stands to make double the amount that they have risked, they would be said to have a 1:2 risk/reward ratio on that particular trade. Derivatives contracts, such as put contracts, which give their owners the right to sell the underlying asset at a specified price, can be used to similar effect.

If an investor prefers to seek a 1:5 risk/reward ratio for a specified investment (five units of expected return for each additional unit of risk), then they can modify the stop-loss order and thus adjust the risk/reward ratio. However, this alters the trade's probability of success..

In the trading example noted above, suppose an investor set a stop-loss order at $18, instead of $15, and they continued to target a $30 profit-taking exit. By doing so, they would certainly reduce the size of the potential loss (assuming no change to the number of shares), but they will have increased the likelihood that the price action will trigger their stop loss order. This happens because the stop order is much closer to the entry point than the target price. So, although the investor may stand to make a proportionally larger gain (compared to the potential loss), they have a lower probability of receiving this outcome.

The Bottom Line

The risk-reward ratio is a measure of potential profit to potential loss for a given investment or project. A low risk-reward ratio is usually preferred, as it allows for higher returns with less risk. A ratio that is too high indicates that an investment could be overly risky. However, a ratio that is too low should be met with suspicion. Investors should consider their risk tolerance and investment goals when determining the appropriate ratio for their portfolio. Diversifying investments, the use of protective put options, and using stop-loss orders can help optimize your risk-return profile.

Correction—March 21, 2024: This article has been corrected to state that a lower ratio means the potential reward is greater than the potential risk, and a high ratio means the opposite.