Risk–reward ratio in trading/investing:

1. Definition

Risk–reward ratio (R:R) compares the potential loss (risk) on a trade to the potential profit (reward).

2. Formula

\[

\text{Risk–Reward Ratio} = \frac{\text{Potential Loss per trade}}{\text{Potential Profit per trade}}

\]

3. How to calculate (step-by-step)

For a buy trade in a stock:

- Entry price (E) – price at which you buy

- Stop-loss (S) – price where you will exit if trade goes wrong

- Target (T) – price where you will book profit if trade goes right

Then:

- Potential Loss = E – S

- Potential Profit = T – E

- Risk–Reward = (E – S) / (T – E)

4. Example (for illustration only)

- Stock: XYZ

- Entry (E) = ₹100

- Stop-loss (S) = ₹95

- Target (T) = ₹115

- Risk = 100 – 95 = ₹5

- Reward = 115 – 100 = ₹15

- Risk–Reward = 5 / 15 = 1:3

Meaning: you are risking ₹1 to potentially make ₹3.

5. How traders use it (conceptual, not advice)

- Many traders look for setups with at least 1:2 or better (risk ₹1 to make ₹2), some prefer 1:3+.

- A good risk–reward ratio does not guarantee profit; it only improves the math if you manage position sizing and follow your stop-loss.

- Even with a lower win rate (say 40%), a strong R:R (like 1:3) can make a strategy profitable over many trades.

6. Key points to remember

- Define stop-loss and target before entering a trade.

- Don’t move your stop-loss away just to avoid a loss—it worsens your risk–reward.

- Always combine risk–reward with position sizing and overall risk per trade (example: not risking more than 1–2% of total capital per trade—this is a common rule of thumb, not a recommendation).

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