Glossary / Risk

Risk/Reward Ratio

A risk/reward ratio compares how much you might lose if an idea fails with how much you might gain if it works. It is a planning tool, not a promise that either outcome will happen.

Why it matters

Risk/reward helps investors avoid ideas where the upside looks small relative to the downside. It also makes position sizing more disciplined because the entry price, upside target, and invalidation point have to be named before the trade is evaluated.

Example

If a stock trades at 100, a research plan estimates reasonable upside to 115 and downside to 95, the possible gain is 15 while the possible loss is 5. That is often described as a 3-to-1 reward-to-risk setup. The estimate still depends on assumptions that can be wrong.

Limitations

The ratio does not include probability by itself. A 5-to-1 payoff can still be unattractive if the probability of success is very low or the downside estimate is unrealistic. Liquidity, volatility, news risk, and correlation with other holdings also matter.