The risk/reward ratio marks the potential reward an investor can earn for each dollar they risk on an investment. Many investors use risk/reward ratios to match the expected returns of an investment with the quantity of risk they need to undertake to earn these returns.
Consider the subsequent example: an investment with a risk-reward ratio of 1:7 suggests that an investor is willing to risk $1, for the prospect of earning $7. Alternatively, a risk/reward ratio of 1:3 signals that an investor should expect to take a position $1, for the prospect of earning $3 on their investment.
Traders often use this approach to plan which trades to require, and therefore the ratio is calculated by dividing the quantity a trader stands to lose if the worth of an asset moves in an unexpected direction (the risk) by the quantity of profit the trader expects to possess made when the position is closed (the reward).
In many cases, market strategists find the perfect risk/reward ratio for his or her investments to be approximately 1:3, or three units of expected return for each one unit of additional risk. Investors can manage risk/reward more directly through the utilization of stop-loss orders and derivatives like put options.
The risk/reward ratio is usually used as a measure when trading individual stocks. The optimal risk/reward ratio differs widely among various trading strategies. Some trial-and-error methods are usually required to work out which ratio is best for a given trading strategy, and lots of investors have a pre-specified risk/reward ratio for his or her investments.