What the risk/reward ratio is
The risk/reward ratio compares how much you stand to lose on a trade against how much you stand to make. Written as a reward-to-risk figure, a 3:1 means you are risking 1 to make 3: if the trade goes against you it costs one unit, and if it works it pays three. The ratio is a way of asking, before you commit, whether the payoff is worth the amount you are putting at risk.
It is a comparison of two distances on your chart, not a prediction. It says nothing about how likely the trade is to work. That is exactly why it can mislead you on its own, and why the second half of this guide, the win rate, matters just as much.
How to compute it from your levels
You do not guess the ratio, you read it off the three prices you already have: your entry, your stop, and your target. Reward is the distance from your entry to your target. Risk is the distance from your entry to your stop. Divide reward by risk and you have the ratio.
Say you enter at $50.00, place your stop at $48.00, and set your target at $56.00. Your risk is $50.00 minus $48.00, which is $2.00 per share. Your reward is $56.00 minus $50.00, which is $6.00 per share. Your risk/reward is $6.00 divided by $2.00, or 3:1. The trade pays three times what it risks if it reaches the target. Notice that the ratio came straight out of the levels, no opinion required.
The breakeven win-rate math
Here is the part most traders skip. Every reward-to-risk ratio has a matching win rate you must clear just to break even. The formula is simple: for a reward-to-risk of R, the breakeven win rate is 1 divided by (1 plus R). The bigger your reward relative to your risk, the lower the win rate you can survive on.
| Reward-to-risk | Breakeven win rate |
|---|---|
| 1:1 | 50% |
| 2:1 | 33.3% |
| 3:1 | 25% |
| 4:1 | 20% |
Read it like this. At 1:1 you have to win more than 50% of the time to make money. At 2:1 you only need to win more than 33.3%. At 3:1, more than 25%. At 4:1, more than 20%. Anything above the breakeven line is profit; anything below it bleeds. This single table is why a trader who is right less than half the time can still be deeply profitable.
Why higher R/R forgives a lower win rate
A larger reward-to-risk gives you more room to be wrong. When each winner pays three or four times what each loser costs, you can lose the majority of your trades and still come out ahead, because the wins more than cover the string of small losses. That is the whole appeal of trend and breakout styles: they are wrong often, but the winners are large enough that the math works.
The trade-off is that big-reward setups usually hit less often, so you cannot just chase the highest ratio and assume you are winning. A 5:1 that fills 10% of the time is a losing strategy. Risk/reward buys you a lower breakeven win rate; whether you actually clear that lower bar is a separate question you still have to answer honestly.
Using it to filter trades
In practice, most disciplined traders set a floor. Many skip any setup below roughly 1.5:1 or 2:1 unless their win rate on that specific pattern is unusually high, because the margin for error at 1:1 is too thin to cover slippage and the occasional stop-out. The ratio becomes a quick gate: measure it from your levels before you enter, and if it does not clear your floor for the win rate you actually have, you pass.
The honest way to use risk/reward is always as one half of a pair. The ratio sets the bar; your win rate tells you whether you clear it. Multiply the two together and you get expectancy, the real number that says whether a strategy makes money over time. Neither the ratio nor the win rate means anything alone, and that is the whole point.