How do I assess the risk-reward ratio of a trade?

The risk-reward ratio in trading helps investors measure potential returns against possible losses before entering a trade. It is a simple calculation that compares the expected profit (reward) to the amount of risk taken. A good risk-reward ratio allows traders to make informed decisions and minimize losses while maximizing gains.

1. What is the Risk-Reward Ratio?

The risk-reward ratio is a financial metric that compares potential profit to potential loss in a trade. It is calculated using the formula:

Risk-Reward Ratio = Potential Profit / Potential Loss

For example, if a trader is willing to risk ₹100 to gain ₹300, the risk-reward ratio would be 1:3. A ratio of 1:2 or higher is often considered ideal for profitable trading.

2. How to Calculate the Risk-Reward Ratio?

To calculate the risk-reward ratio, follow these steps:

• Identify the entry price of the stock.
• Set the stop-loss price (where you will exit if the trade goes against you).
• Determine the target price (expected profit level).
• Use the formula: (Target Price - Entry Price) ÷ (Entry Price - Stop-Loss Price)

For example, if you buy a stock at ₹500, set a stop loss at ₹480, and aim for a target of ₹550, the risk-reward ratio would be:

(550 - 500) ÷ (500 - 480) = 50 ÷ 20 = 2.5

This means for every ₹1 you risk, you have the potential to earn ₹2.5.

3. What is a Good Risk-Reward Ratio?

A good risk-reward ratio depends on your trading strategy and market conditions. Generally, traders prefer:

• 1:2 or higher – This means the potential profit is at least twice the risk.
• 1:3 or 1:4 – Higher reward ratios reduce the number of winning trades needed to be profitable.
• Avoiding 1:1 ratios – These provide little advantage and make it harder to stay profitable in the long run.

Choosing a higher risk-reward ratio improves your chances of long-term trading success.

4. Final Thoughts

Assessing the risk-reward ratio before entering a trade is essential for managing risk and improving profitability. A well-calculated ratio helps traders make informed decisions, minimize losses, and maximize potential returns.

Always use stop-loss orders and profit targets to maintain discipline and protect your capital while trading.