The profit to risk ratio is used by traders to compare potential profits with potential losses. To calculate the profit to risk ratio, divide the possible profit from a trade by the amount you stand to lose if your position is closed at the stop loss level.

The most commonly used profit to risk ratio values are 2:1, 3:1 and 4:1. These ratios will depend on the trading strategy you adopt. Although there are many factors that affect the risk of a trade (market volatility or capital management strategy), a fixed profit/risk ratio can determine your long-term success.

Suppose we decide to take a long position in the stock of company ABC. We buy 100 lots, which are equivalent to 100 shares at USD 20 each. The value of the entire position is USD 2000 . We assume that the value of these shares will increase in the near future to 30 USD. The price level at which we conclude that we would like to limit losses is 15 USD. Stop loss at this level will ensure that our potential losses should not exceed 500 USD.

In our example, we are willing to risk USD 5 per share to receive an expected return of USD 10. Since we risked funds that are half of the potential profit, our profit/risk ratio is 2:1. If our target was US 15 per share, our ratio would be 3:1. Maintaining such a profit/risk ratio means that one profitable transaction can cover two or three losses.

It should be remembered, however, that although the profit/risk ratio helps us manage probability, it does not give us information regarding the probability of the transaction's success itself.

How to calculate risk to reward ratio?