Risk-Reward Ratios and Profit Targeting
The Mathematics of Risk-Reward Ratios
One of the most powerful concepts in trading is the risk-reward ratio — the relationship between the potential loss on a trade (risk) and the potential gain (reward). Understanding and consistently applying favourable risk-reward ratios is what allows traders to be profitable over the long term even with a win rate below 50%.
The risk-reward ratio is expressed as a ratio of potential loss to potential gain. A 1:2 risk-reward ratio means you are risking 1 unit to potentially gain 2 units. For example, if your stop-loss is 30 pips away and your take-profit is 60 pips away, you have a 1:2 risk-reward ratio.
Why Risk-Reward Determines Long-Term Profitability
Let us do the mathematics. Suppose you take 100 trades with a 1:2 risk-reward ratio, risking $100 per trade:
- With a 40% win rate: 40 wins × $200 = $8,000 profit; 60 losses × $100 = $6,000 loss. Net profit: $2,000. You are profitable despite losing more than half your trades.
- With a 50% win rate: 50 wins × $200 = $10,000 profit; 50 losses × $100 = $5,000 loss. Net profit: $5,000.
This illustrates why risk-reward is arguably more important than win rate. A trader with a 40% win rate using 1:2 risk-reward will outperform a trader with a 60% win rate using 1:1 risk-reward over the long run.
Setting Take-Profit Targets
Your take-profit target should be set at a price level that is logical given the market structure. Common approaches include:
- The next key resistance level (for long trades) or the next key support level (for short trades).
- Fibonacci extension levels — as discussed in the Technical Analysis Mastery course.
- A measured move — the size of a chart pattern is often used to project the expected move after a breakout.
- A fixed risk-reward target — simply placing the take-profit at 2× or 3× the distance of the stop-loss.
Minimum Acceptable Risk-Reward
As a rule of thumb, many professional traders refuse to take any trade with a risk-reward ratio below 1:1.5. Preferably, they target 1:2 or better. Any trade where the potential loss exceeds or equals the potential gain is considered unfavourable and should be passed on, regardless of how attractive the setup looks.
Adjusting for Win Rate
Your minimum acceptable risk-reward ratio should be informed by your strategy's historical win rate. If backtesting shows your strategy wins 65% of the time, you can accept a lower risk-reward ratio (even 1:1 would be profitable). But if your win rate is closer to 40%, you need a minimum of 1:2 or higher to remain profitable. Always know your numbers.
Summary
Risk-reward ratios are the mathematical engine that drives long-term profitability. Commit to a minimum ratio, plan your exits before entering every trade, and let the mathematics work in your favour. In the final lesson of this course, we tie everything together into a complete risk management framework for your trading plan.