The risk-reward ratio (R:R or RRR) compares the potential loss (distance to stop loss) to the potential gain (distance to target) for each trade. A 1:2 R:R means you risk $1 to potentially make $2. By maintaining favourable risk-reward ratios, a trader can be profitable even with a win rate below 50%.
R:R = Stop loss distance ÷ Take profit distance. 1:2 R:R with 40% win rate = profitable. 1:3 R:R with 30% win rate = profitable. Minimum R:R of 1:1.5 is recommended for most strategies. R-multiples: express all trades in terms of R (initial risk). A 3R winner = 3× your initial risk.
Only take setups where the reward is at least 1.5× the risk. Define your stop loss first, then determine if the target provides adequate R:R. If the R:R is below your threshold, skip the trade regardless of the setup quality.
Take partial profits at 1R, trail remainder for 2-3R. If a setup's R:R decreases (target gets hit by new resistance, or you need a wider stop), skip it. Reassess R:R if the trade approaches your target — does the remaining R:R justify holding?
Applies to every trade on every timeframe
Risk-reward is not just about calculating R:R before entry. You must also consider the PROBABILITY of price reaching your target. A 1:10 R:R is worthless if the probability of reaching that target is 2%.
A maximum drawdown limit is a predefined loss threshold that triggers mandatory action — reducing size, stopping trading, or reviewing strategy. Common limits: daily max loss (e.g., 3%), weekly max loss (e.g., 5%), monthly max loss (e.g., 10%), and total max drawdown (e.g., 20%). Professional trading firms and prop firms enforce strict drawdown rules.
The Sharpe ratio measures risk-adjusted return by dividing excess return (above the risk-free rate) by the standard deviation of returns. The Sortino ratio improves on Sharpe by penalising only downside deviation, recognising that upside volatility is desirable. Both ratios help traders compare strategies on a level playing field and identify which approaches deliver the best returns for their level of risk.
Hedging is the practice of taking offsetting positions to reduce exposure to adverse price movements in your primary holdings. Rather than closing a profitable position or accepting full downside risk, hedging allows traders to protect capital during uncertain periods while maintaining their core exposure. Effective hedging balances protection cost against the risk being mitigated.
The Kelly Criterion is a mathematical formula for determining the optimal bet size to maximise long-term growth rate. Kelly = (bp - q) / b, where b = odds received, p = probability of winning, q = probability of losing. While theoretically optimal, full Kelly is too aggressive for most traders — half-Kelly or quarter-Kelly is more practical.