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Mastering the Risk Versus Reward Ratio for Successful Trading

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The risk versus reward ratio (also known as the risk/reward ratio) is a fundamental concept in trading and investing. It has been used by traders and investors for decades as a guideline for evaluating potential trades. While there isn’t a single individual credited with its invention, the concept evolved through the development of modern portfolio theory and technical analysis.

Key Figures in the Development of the Risk/Reward Concept

  1. Benjamin Graham (1894–1976)
    • Known as the “father of value investing,” Benjamin Graham introduced the concept of intrinsic value and margin of safety in his seminal works Security Analysis (1934) and The Intelligent Investor (1949).
    • While Graham didn’t explicitly refer to a “risk/reward ratio,” his approach emphasized minimizing downside risk while seeking reasonable upside potential—a core idea behind the ratio.
  2. Jesse Livermore (1877–1940)
    • One of the most famous traders in history, Jesse Livermore discussed the importance of controlling losses and letting winners run in his book Reminiscences of a Stock Operator (published in 1923, written by Edwin Lefèvre).
    • Livermore’s trading rules implied a focus on maximizing reward while limiting risk, a principle closely aligned with the modern risk/reward ratio.
  3. Richard Donchian (1905–1993)
    • Often regarded as the “father of trend following,” Richard Donchian developed systematic trading strategies in the mid-20th century.
    • He emphasized the use of stop-loss orders and letting profits run, which directly relates to managing risk and reward.
  4. Jack D. Schwager (b. 1948)
    • In his Market Wizards series (1989 onward), Schwager interviewed many of the world’s greatest traders, who repeatedly emphasized the importance of a favorable risk/reward ratio in successful trading.
    • These books popularized the concept of the risk/reward ratio among retail traders.

Evolution of the Concept

  • Early Days of Investing (Pre-20th Century):
    In the early days of the stock market, traders and investors focused more on fundamental analysis without a structured method for evaluating risk versus reward.
  • 1920s–1940s:
    The rise of technical analysis and speculative trading during the early 20th century led traders like Jesse Livermore to develop informal guidelines on balancing risk and reward.
  • Mid-20th Century:
    The introduction of modern portfolio theory by Harry Markowitz in 1952 formalized the understanding of risk and return in financial markets. Markowitz’s work laid the foundation for quantitative measures of risk.
  • Late 20th Century:
    The concept of the risk/reward ratio gained widespread acceptance among retail traders and institutional investors. Books like Market Wizards and the teachings of traders like Richard Dennis (of Turtle Traders fame) helped establish it as a core principle of trading strategy.

While no single person can be credited with inventing the risk/reward ratio, the concept has been shaped by several influential traders and theorists over time. Jesse Livermore, Benjamin Graham, and Richard Donchian were among the earliest to advocate balancing potential losses against potential gains. The ratio became a key part of trading strategies with the rise of modern portfolio theory and the popularization of systematic trading in the mid-20th century.

Calculating the Risk Versus Reward Ratio

The risk versus reward ratio (often written as risk/reward ratio) is a simple and useful metric for evaluating the potential profit versus potential loss of a stock trade. Here’s a step-by-step guide to calculating it with an Excel spreadsheet for download below:

Step 1: Identify Entry Point

  • Determine the price at which you plan to enter the trade.

Step 2: Determine Stop Loss Level

  • This is the price at which you’ll exit the trade if it moves against you to limit your loss.
  • Risk is calculated as the difference between the entry point and the stop loss.
risk versus reward ratio calculation 2

Step 3: Determine Profit Target

  • This is the price at which you’ll exit the trade if it moves in your favor.
  • Reward is calculated as the difference between the profit target and the entry point.
risk versus reward ratio calculation 1

Step 4: Calculate the Risk/Reward Ratio

  • The ratio compares how much you’re risking to how much you expect to gain.
risk versus reward ratio calculation 3

Step 5: Interpret the Ratio

  • A lower ratio indicates a more favorable trade setup.
  • Common acceptable ratios are 1:2 or 1:3, meaning you risk $1 to potentially gain $2 or $3.

Example Calculation

  • Entry Price: $100
  • Stop Loss Price: $95
  • Profit Target: $115
  1. Risk: $100 – $95 = $5
  2. Reward: $115 – $100 = $15
  3. Risk/Reward Ratio: $5 / $15 = 1:3

This means you’re risking $1 to potentially gain $3, which is a favorable trade setup.

Tips for Using Risk/Reward Ratios

  1. Always aim for a risk/reward ratio greater than 1:2 to ensure long-term profitability.
  2. Combine the ratio with a high win rate (percentage of successful trades) to improve overall trading performance.
  3. Use risk management strategies like position sizing and diversification to protect against large losses.

Excel Risk versus Reward Spreadsheet Download

💡 Here’s an Excel spreadsheet that automatically calculates the risk/reward ratio for your trades. Feel free to use it!
💯 Download the Excel Risk versus Reward Ratio Calculator Spreadsheet

Lance Jepsen
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