Risk-reward ratio is one of the most frequently cited concepts in retail trading — and one of the most frequently misused.
The ratio compares the potential loss on a trade (the risk) to the potential profit (the reward). A 1:2 risk-reward means you are risking ₹1 to make ₹2. A 1:3 ratio means you are risking ₹1 to make ₹3.
The confusion begins when traders treat the ratio as a property of a setup rather than a measurement they derive from their stop-loss and target levels.
How to Calculate Risk-Reward
Risk is the distance between your entry price and your stop-loss level, multiplied by your position size.
Reward is the distance between your entry price and your target level, multiplied by your position size.
Example on NSE:
- Stock: INFY at ₹1,840
- Entry: ₹1,840
- Stop-loss: ₹1,800 (40 points below entry)
- Target: ₹1,920 (80 points above entry)
- Risk-reward: 40:80 = 1:2
You are risking 40 points to make 80. If the stop is hit, you lose 40 per share. If the target is hit, you gain 80.
Why Risk-Reward Interacts with Win Rate
Risk-reward ratio only becomes meaningful when read against your win rate. Here is why:
Suppose you take 10 trades, all with a 1:2 risk-reward, risking ₹5,000 per trade to target ₹10,000.
- If you win 5 and lose 5: 5 × ₹10,000 − 5 × ₹5,000 = ₹25,000 net profit
- If you win 4 and lose 6: 4 × ₹10,000 − 6 × ₹5,000 = ₹10,000 net profit
- If you win 3 and lose 7: 3 × ₹10,000 − 7 × ₹5,000 = −₹5,000 net loss
With a 1:2 ratio, a win rate of 34% or higher produces profit. The system doesn't require you to be right most of the time — it just requires discipline on the ratio.
At 1:3 ratio (risking ₹5,000 to make ₹15,000), you only need a 26% win rate to be profitable.
This is the reason experienced traders are willing to accept setups where they expect to lose more often than they win. The math works in their favour even with a minority of winning trades.
Where Traders Set Targets — and Where They Should
The most common mistake is setting targets at an arbitrary multiple of the stop-loss. "I want 1:3 so my target is 3× my risk above entry" — without checking whether there is a technical reason for price to reach that level.
What makes a valid target:
- The next significant resistance level — the price area where sellers have previously turned back buyers
- A prior swing high in the stock's recent history
- A round number with visible option OI concentration (in index trades near expiry)
- A measured move projection (the height of a pattern added to the breakout level)
If the only justification for your target is "it gives me a 1:3 ratio," the target is arbitrary. The market does not care what ratio you need. Price will move to where there is supply, not to where you have placed a profit limit.
When 1:3 Is the Wrong Goal
There are setups where a 1:2 target is at a strong resistance level and the 1:3 level is above it — in open air with no technical basis. Taking the trade with a 1:2 target and a realistic stop is correct. Adjusting the entry or widening the stop to force a 1:3 ratio corrupts the setup.
The ratio is an output of setup analysis, not an input.
Conversely, if a 1:3 target is technically sound (at a level that price has rejected before, with room to move), that is the appropriate target even if a "worse" ratio would have you banking profit earlier.
Risk-Reward in F&O
In options, risk-reward needs adjustment. When you buy an option, your maximum loss is the premium paid — this is your risk. Your target is the premium you expect to exit at. But IV crush, theta decay, and time left to expiry all affect what your option premium will be worth even if the underlying moves to your target.
A Nifty call bought at ₹150 with a target of ₹300 on a 200-point underlying move will not necessarily reach ₹300 if IV collapses after the event you expected the move around. The risk-reward arithmetic requires including the time and volatility components for options, not just the underlying movement.
The Discipline Requirement
The ratio only delivers its mathematical advantage if both legs are held to. Cutting losses before the stop is hit (not necessarily wrong, if the thesis has changed) and moving the stop to protect profit (can be managed if done with a trailing approach) are different from the common failure mode: moving the stop further away when a loss is close to the trigger.
Every loss that runs past the stop erodes the ratio. The edge the system provides is neutralised by undisciplined stop management.
For educational purposes only. Profitma is not a SEBI-registered investment adviser or research analyst. Nothing in this article constitutes investment advice.