Risk/Reward Ratio Calculation Formula

The calculation of the Risk/Reward ratio is extremely simple. You are going to enter into a trade, buying an instrument for 100 US dollars and selling it for 150 US dollars, having bought 10 units of this instrument. The estimated profit is (150-100) x 10 = $500. You are going to place a protective stop-loss order at $90, so the estimated amount of possible loss will be (100-90) x 10 = $100. Thus, the risk/reward ratio will be 1:5 (500:100 = 5).

However, calculating the favorable ratio of risk/reward may be insufficient, and other parameters may be necessary for planning the transaction.

A professional trader with some experience thanks to statistics of his/her trades on the market will be able to derive the average ratio of losing trades to successful ones, i.e. to calculate the winning ratio. It is also very simple: winning ratio = quantity of profitable trades / total amount of trades.

• In addition, in a similar way thanks to statistics, the loss ratio = number of losing trades / total number of trades is calculated.
• By calculating these ratios, the trader will be able to calculate the expectation ratio = (risk/reward ratio X win ratio) - (loss ratio).
• Thus, if the result is higher than zero, the planned trade can give the trader a profit, and if it is lower than zero, it can lead to a loss.

Thanks to the calculation of the waiting ratio, the trader will be able to calculate for himself the probability of successful completion of the transaction and to make the appropriate conclusions.

For example, at a risk/reward ratio of 1:5, the probability of a successful transaction can be 15%, while at a risk/reward ratio of 1:2 it is 80%. Clearly, the second option has a much better chance of success than the first. These calculations can be used, for example, when planning the opening of a position on the possible achievement by the instrument of the base or top, assuming the soonest reversal of the trend. When you get the expectation ratio, say, 0.5, you can open the position with 50% confidence in the deal's success.

But there is a "but" here as well - there is no guarantee that the second trade will work and the first one will not. Moreover, there is a probability that both trades will result in a loss or both will be profitable. Nevertheless, the calculation of the expected ratio can increase the chances of getting profit from the planned trading operation.

And another important point: in order to make a decision to open a position or not, in your risk management you must also consider the volatility of the market, the "behavior" of the instruments with which the instrument being traded has a correlation (if any), and the size of your deposit.

If the instrument being traded is in itself very volatile, such as the US30 index, where the daily movement can be more than a thousand pips, the calculation of the potential profit and loss will be different, i.e., the potential loss can be unacceptable to the trader, given the size of his trading balance.

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