The risk-reward ratio compares how much a trade can lose with how much it might gain. You set a stop-loss (where you exit if wrong) and a target (where you plan to take profit). The distance from entry to stop is the risk; the distance from entry to target is the reward.
Risk-reward = (entry − stop) : (target − entry)
If you buy a stock at ₹1,000 with a stop at ₹980 and a target at ₹1,040, you risk ₹20 to make ₹40. That is written as a risk-reward of 1:2 (some people write it the other way, as a "reward-to-risk" of 2). It is one of the first things experienced traders check before taking any trade.
A worked example with NIFTY
Say NIFTY is at 25,000 and you buy NIFTY futures because the index has bounced from support at 24,900. You put the stop at 24,880, 120 points below entry. The nearest resistance is around 25,300, 300 points above. The risk-reward is 120 : 300, or 1 : 2.5.
Now say the same setup appears when NIFTY is already at 25,200. The stop is still below 24,900 (now 320 points away) and the target is still 25,300 (100 points away). The risk-reward is 320 : 100, about 3 : 1 against you. The chart idea is the same, but the trade is much worse because of where you enter. That is the practical value of the ratio: it stops you chasing a move that has already happened.
Why the ratio alone is not enough: win rate
A 1:3 trade sounds better than a 1:1 trade, but not if it works far less often. What matters is the combination of the ratio and the win rate, the share of trades that reach the target rather than the stop. The break-even win rate for a given ratio is:
Break-even win rate = risk ÷ (risk + reward)
| Risk : reward | Win rate needed just to break even (before costs) |
|---|---|
| 1 : 0.5 | 67% |
| 1 : 1 | 50% |
| 1 : 2 | 33% |
| 1 : 3 | 25% |
| 1 : 5 | 17% |
A trader who wins only 40% of the time can still make money with a 1:2 ratio. A trader who wins 70% of the time can still lose money if the average loss is three times the average win. Costs push every break-even figure up a little, more so for small intraday targets.
Expectancy: the number that really matters
To judge a method over many trades, combine the two ideas into expectancy, the average result per trade:
Expectancy = (win rate × average win) − (loss rate × average loss)
Example. Over 50 trades you won 20 (40%) with an average win of ₹6,000 and lost 30 (60%) with an average loss of ₹3,000. Expectancy = 0.4 × 6,000 − 0.6 × 3,000 = 2,400 − 1,800 = ₹600 per trade, before costs. If your costs average ₹250 per trade, the real figure is about ₹350. Positive, but thinner than it looked.
You cannot know your real win rate and averages from a few trades. You need a record of many: that is what a trading journal is for, and past data tested with the backtester gives an early estimate before risking money.
Risk-reward in options: buyers and sellers
Options make the trade-off between ratio and win rate very visible.
- Option buyers risk only the premium and can gain several times it. The ratio looks excellent. But many bought options expire worthless or lose value to time decay, so the win rate is often low.
- Option sellers collect a small premium and can lose many times it. The ratio looks poor. But most of the time the price stays inside the range, so the win rate is often high. A few large losses can wipe out many small wins, which is why sellers need strict exits or hedges.
The payoff diagram shows both sides at once. On the strategy builder you can put together a position and see its maximum profit, maximum loss and break-even points. For a bull call spread (buy one call, sell a higher call), for example, both the maximum loss and maximum gain are fixed, so the ratio can be read straight off the chart. See reading payoff diagrams.
A live example: the expected move as a reality check
A target that needs a move far larger than the market expects is a hopeful target. The options market's own estimate of how far NIFTY may travel by expiry is a useful check on any target:
Compare the "Range" with your target. A target inside the range is a move the market considers ordinary. A target well outside it may still happen, especially around events, but you should expect it to be hit less often, which lowers your win rate. Many option buyers find that their 1:3 trades need a move larger than the expected move, which is the reason so many of them lose.
Setting realistic targets
- Use the chart. Put the target just before the next resistance (for a buy) or support (for a sell), where other traders are likely to take profit.
- Use volatility. The Average True Range tells you how far a stock usually moves in a day. A one-day target of five ATRs is unlikely.
- Use partial exits. Some traders book half at a near target and trail a stop on the rest, which raises the win rate while keeping some of the larger reward.
- Do not move the target closer out of fear or further out of greed after entering. Both change the numbers the trade was planned on.
A short pre-trade checklist
Putting the ideas together, many traders run through the same few questions before every entry. Writing the answers down takes less than a minute and is the raw material for your journal later:
- Where is the stop? The price that proves the idea wrong, from the chart.
- Where is the target? The next realistic level, checked against the Average True Range or the expected move.
- What is the ratio? If it is worse than the minimum you set for yourself, skip the trade or wait for a better entry.
- What size? Money at risk ÷ distance to the stop, as in the position sizing guide.
- What would make me exit early? An event, a time limit, or a change in the market such as a sudden jump in India VIX.
Over a few months, comparing the ratio you planned with the result you actually got shows whether your targets are realistic and whether you are cutting winners short.
Common mistakes
- Quoting a ratio with an imaginary target. A 1:5 trade with a target nobody believes in is not really 1:5.
- Ignoring win rate. Chasing high ratios with very low success can be as bad as the reverse.
- Moving the stop. Widening the stop after entry quietly destroys the ratio you planned.
- Forgetting costs and slippage. On a ₹20 risk and ₹40 target, a few rupees of costs on each side change the real ratio noticeably. See trading costs.