Quick definition — On this page, risk/reward ratio means the comparison, defined before a trade, between planned monetary loss and potential gross gain. The notation 1:2 means “risk 1 to try to gain 2”.
The term has no single universal convention. The CFTC glossary describes it as the relationship between the probability of loss and profit; many platforms and journals instead use risk/reward for the ratio between the size of the planned loss and the potential gain. To remove ambiguity, this page calls the latter the planned payoff ratio and always states the order risk:reward.
The ratio helps frame a hypothesis before entry. It does not state what the outcome will be, does not automatically include the probability of reaching the favorable exit and does not make a trade valid merely because the number is high.
Formula and the 1R unit
First define initial risk 1R: the amount you expect to lose given the planned size, entry and invalidation exit. A stop-loss order does not, however, guarantee that execution price.
Planned payoff ratio (b) = potential gross gain / planned initial risk
If 1R is $50 and the potential gain is $100, then b = 100 / 50 = 2: under this page's convention, risk:reward = 1:2. The calculation must use monetary amounts consistent with position size, tick or point value and currency; comparing price distances alone can mislead when exposure changes.
From plan to verifiable outcome
Planned ratio and realized outcome are not the same thing
| Item | When measured | What it contains |
|---|---|---|
| Initial 1R | Before entry | Planned monetary loss with size and invalidation defined |
| Planned payoff | Before entry | Potential gross gain divided by 1R |
| Realised outcome | After closing | Actual fills, partial exits, costs and quantities executed |
| After closing | Realised net P&L divided by initial 1R |
A plan with 1R = $50 and a potential gross gain of $100 starts at 1:2. If a losing trade closes at −$55 because of execution and costs, the outcome is −1.10R; if a winning trade nets +$92, the outcome is +1.84R. The theoretical target does not turn those results into −1R or +2R.
Break-even probability: useful, but conditional
If every loss were exactly −1R, every win exactly +bR, there were no costs, and every order executed as planned, the break-even win probability would be:
pBE = 1 / (1 + b)
With b = 2, the arithmetic result is 1 / 3, or about 33.3%. This is not a forecast and does not mean that a 1:2 trade has a 33.3% chance of success. Costs, slippage, gaps, partial exits, correlation across positions and non-binary outcome distributions change the effective threshold.
There is no universal 1:2 rule
A higher ratio is not automatically better: it may require a less probable or unrealistically executable exit. A ratio below 1:2 is not automatically unacceptable: it may belong to a process with a higher success frequency and sustainable costs. Both claims must be tested on comparable data that were not selected after the fact.
The decision belongs in the trading plan: instrument, horizon, exit rules, estimated probability, outcome dispersion and frictions must be consistent. The ratio alone does not prove profitability, robustness or suitable risk.
Operating procedure
- Define invalidation, intended exit, position size and monetary 1R before entry.
- Estimate gross gain from a plausible exit and any partial management already specified.
- Calculate the ratio and state the convention:
risk:reward, not an ambiguous “R/R”. - Model commissions, spread, slippage, gaps and non-execution; do not treat stop or target prices as guaranteed.
- Compare the plan with a homogeneous sample that includes losses, wins, costs and process breaches.
- After the trade, record net P&L and the realized R-multiple without rewriting initial 1R.
Limit — The risk/reward ratio is a conditional description of the plan, not an entry signal or a maximum-loss guarantee. Market and execution conditions can produce very different outcomes.
Sources
- CFTC, Futures Glossary — defines risk/reward ratio as the relationship between the probability of loss and profit and notes its use in trade selection or comparison.
- CME Group, Position and Risk Management — relates capital at risk per trade to multiple factors and to the account's size and financial profile.
- CME Group, Proper Position Size — shows the relationship among a planned stop, monetary value and position size.
- Investor.gov, Stop, Stop-Limit, and Trailing Stop Orders — explains that a stop price does not guarantee the execution price and that a stop-limit order may not execute.
- Investor.gov, How Fees and Expenses Affect Your Investment Portfolio — describes commissions and other transaction costs that reduce net results.