TL;DRThe relationship between how much you stand to lose and how much you stand to gain on a trade. This ratio, combined with your win rate, determines whether your trading is profitable over time.
Risk-reward ratio compares the distance to your stop loss (risk) with the distance to your profit target (reward). If you're risking 10 points to make 20 points, your risk-reward ratio is 1:2.
The ratio is always expressed as risk first, then reward. A 1:3 ratio means you're risking 1 unit to make 3 units. A 1:1 ratio means your risk and reward are equal.
Risk-reward ratio only tells half the story. The other half is your win rate.
With a 1:2 risk-reward ratio, you only need to win 34% of the time to break even (before commissions). With a 1:1 ratio, you need to win more than 50%. With a 1:3 ratio, you only need to win 26%.
The formula is: breakeven win rate = 1 / (1 + reward/risk). For 1:2, that's 1 / (1 + 2) = 33.3%.
Expectancy combines risk-reward and win rate into a single number that tells you how much you'll make per dollar risked over many trades.
Expectancy = (win rate x average win) - (loss rate x average loss). If your average winner is $600, your average loser is $300, and your win rate is 45%: expectancy = (0.45 x $600) - (0.55 x $300) = $270 - $165 = $105 per trade.
Positive expectancy means you'll make money over time. Negative expectancy means you'll lose money. No amount of risk management can fix a negative expectancy strategy.
There's no universally correct ratio. It depends on your strategy and market conditions.
Scalping strategies often use 1:1 or even 1:0.75 ratios but compensate with high win rates (60-70%). Swing trading and breakout strategies often use 1:2 or 1:3 ratios with lower win rates (35-50%).
The key is to know your strategy's expected win rate and make sure the math works. A 1:1 ratio with a 45% win rate is a losing strategy. A 1:2 ratio with a 40% win rate is a winning strategy.
1:2 ratio on ES
You buy ES at 5,200 with a stop at 5,190 (10-point risk, $500) and a target at 5,220 (20-point reward, $1,000).
Your risk-reward ratio is 1:2. If this setup wins 40% of the time: (0.40 x $1,000) - (0.60 x $500) = $400 - $300 = $100 expected profit per trade. Over 100 trades, that's $10,000 in expected profits.
Why 1:1 with low win rate fails
You trade a 1:1 setup risking $500 to make $500. Your backtest shows a 45% win rate.
Expectancy: (0.45 x $500) - (0.55 x $500) = $225 - $275 = -$50 per trade. This strategy loses $50 on average per trade. Over 100 trades, you'd lose $5,000. Either improve the win rate above 50% or increase the reward relative to the risk.
Fixating on risk-reward ratio while ignoring win rate
A 1:5 ratio sounds great, but if the target only gets hit 10% of the time, the strategy loses money. Always evaluate both together.
Moving your stop loss to create a better ratio on paper
Widening your stop to reduce the risk number doesn't reduce actual risk. It increases your dollar exposure. Set stops based on market structure, not to hit a target ratio.
Moving your profit target closer because you're afraid of giving back gains
Cutting winners short destroys your actual risk-reward ratio. If your backtest says 1:2 works, trust the data and let winners run to the target.