The Risk/Reward Ratio is a tool implemented by traders and investors to compare the expected returns of a trade or investment in direct relation to the amount of risk undertaken to capture the return. It is a mathematical calculation performed by the trader who divides the total amount of profit they expect to capture (the rewards) by the amount they could potentially lose if price moves against their position (the risk).
An example of a Risk/Reward calculation is detailed below:
A trader is willing to purchase a stock at $10 per share with the expected profit level to be taken at $20 per share. They purchase the stock and then set a protective stop at $5 per share. The trader is therefore willing to risk $5 per share (should the position go against them) in the expectation of making $10 per share should the stock reach the anticipated profit target of $20. Having a reward target of $10 per share and risking only $5 per share therefore creates a Risk/Reward Ratio of 2:1.
