Definition
The Reward/risk ratio quantifies expected profit relative to potential loss on a trade, expressed as the ratio of potential gain to potential loss.
What is Reward/risk ratio?
The Reward/risk ratio is a financial metric used to compare the size of a trade’s potential return to the size of its potential loss. In the futures market it is applied by defining precise entry, stop-loss and take-profit levels so that every contract position carries a quantified reward and a quantified risk. Its uniqueness lies in translating qualitative trade ideas into a numeric proportion that is independent of position size; the same ratio can be applied to a micro contract or a full-sized contract. Traders combine the ratio with leverage, margin requirements and contract specifications to determine position sizing and required capital allocation. Market data providers and educational sites such as Investopedia, Bloomberg and Seeking Alpha frequently reference the reward/risk ratio when explaining trade selection and strategy design.
Key Features of Reward/risk ratio
- Ratio format: Expressed as X:Y (often written 1:3), where X is potential loss and Y is potential profit, or inversely as reward-to-risk.
- Entry/exit dependent: Requires predefined entry, stop-loss and take-profit levels to be meaningful.
- Position-size independent: The ratio itself does not change with contract quantity, enabling comparison across trade sizes and instruments.
- Works across asset classes: Applicable to futures, options, equities, FX and crypto; common in platforms like TD Ameritrade, Fidelity and Schwab.
- Complementary metrics: Used alongside win rate, expectancy and Sharpe-type measures to assess overall strategy performance.
- Execution-sensitive: Realized reward/risk can differ from planned values due to slippage, spreads and margin calls.
- Risk controls: Integrates with margin rules, initial and maintenance margin requirements, and settlement conventions specific to futures contracts.
How Reward/risk ratio Works
In live trading the Reward/risk ratio is calculated by dividing the potential profit target by the potential loss defined by the stop-loss. For futures contracts this calculation must consider the contract’s multiplier, tick value and margin requirements so that the monetary amounts align with exchange specifications and capital at risk. Settlement type—cash or physical—does not change the ratio concept but can affect liquidity and the feasibility of hitting targets; similarly, volatility and margin multipliers will influence the practical placement of stops and targets.
Example: a trader buying a crude oil futures contract at $80.00 sets a stop-loss at $78.00 (risk $2.00) and a profit target at $86.00 (reward $6.00), producing a planned Reward/risk ratio of 6/2 = 3. For a Bitcoin futures position using a $100 notional sized trade, a 5% stop against a 15% profit target results in a 1:3 ratio—meaning each dollar risked aims to return three dollars.
Reward/risk ratio At a Glance
| Item | Value / Formula | Practical Note |
|---|---|---|
| Basic formula | Reward / Risk = (Target Price − Entry Price) / (Entry Price − Stop Price) | Express result as ratio (e.g., 3 or 1:3). Use absolute monetary amounts when sizing positions. |
| Inverse metric | Risk / Reward | Some practitioners prefer risk-to-reward notation; take care to note direction. |
| Futures specifics | Multiply price movement by contract multiplier and tick value | Always convert percentage targets into monetary exposure consistent with margin. |
| Typical use case | Speculation, hedging, arbitrage | Used by retail platforms (e.g., NerdWallet, The Motley Fool) and institutional desks. |
Main Uses of Reward/risk ratio
- Speculation: Traders select trades with attractive reward/risk ratios to pursue asymmetric payoffs; a common approach is to prefer setups where the potential reward is multiple times the potential loss, allowing a lower win rate to still be profitable.
- Hedging: When used for hedging, the ratio helps balance the cost of protection against the size of exposure being mitigated; commercial hedgers set targets that justify the expense and margin of futures contracts.
- Arbitrage: In arbitrage, the reward/risk ratio assists in comparing the expected premium to execution and settlement risk; even small mispricings must clear the hurdle of transaction costs and basis risk to produce a favorable ratio.
Impact of Reward/risk ratio on the Market
Widespread use of the Reward/risk ratio affects market structure through order placement and trader behavior. If many participants target similar reward/risk profiles, clusterings of stops and limits can form, influencing short-term liquidity and the likelihood of stop hunts around technical levels. The metric also contributes to price discovery: aggregated targeting can concentrate buying or selling pressure near common profit targets, which in turn can create predictable intraday patterns observed in futures contracts.
On volatility, the ratio itself does not move prices, but collective adherence to tight stop-losses or aggressive targets can amplify moves during stress periods, increasing realized volatility and the frequency of margin calls. Research and commentary from outlets such as Bloomberg, Yahoo Finance and Morningstar often note that reward/risk-driven activity is a material factor in short-term market dynamics.
Benefits of Reward/risk ratio
- Objective trade selection: Offers a simple numeric criterion to filter trade ideas and prioritize setups.
- Position sizing aid: When combined with capital allocation rules and margin requirements it enables consistent sizing across instruments.
- Supports asymmetric strategies: Allows strategies with low win rates but high payoffs to be modeled and validated.
- Compatibility with automated systems: Easily encoded into rules-based systems and backtests on platforms used by brokers and research services.
Risks of Reward/risk ratio
- Over-simplification: A single planned ratio ignores execution factors such as slippage, widening spreads and partial fills that erode expected reward.
- Leverage amplification: In futures trading high leverage converts a planned reward into potential rapid losses and margin calls if markets gap against the position.
- Misleading without win rate: Favorable ratios do not guarantee profitability unless combined with realistic win-rate assumptions and expectancy calculations.
- Stop clustering and predictability: Publicized or commonly used ratios can lead to predictable zones that other market participants exploit.
Brief History of Reward/risk ratio
The concept of comparing potential reward to potential risk traces to early risk management and utility theory, but the explicit ratio used in trading was popularized with the rise of systematic trading on exchange floors in the 20th century. Retail dissemination accelerated with online financial education and media in the 2000s; by the 2010s publications such as Investopedia, The Motley Fool and broker education hubs like TD Ameritrade and Fidelity made the metric standard in trader curricula.