What is Risk Reward Ratio?

From some of my previous post, you might have seen me mention the term "Risk Reward Ratio" (RRR).

What is this and why is it important to me?

Well, as the name implies, it is simply the ratio between the amount of money I am risking and the amount of money I could potentially earn. How do you know how much you will lose or earn? That is determined by your entry, stop loss and take profit levels. Click here if for more information about them.

Lets take the most recent shorting opportunity that I have identified as an example.

So how do we go about calculating the RRR?

1) We first calculate in absolute value of the potential loss.

$35.72 - $37.66 = $1.94

2) Then, we calculate the absolute value of the potential gain.

$32.64 - $35.72 = $3.08

3) Finally, we divide the potential gain with the potential loss.

$3.08/$1.94 = 1.587

So what does this figure mean?

Basically, for every $1 we are risking, there is a potential to earn $1.59. The higher the RRR ratio, the better. Everyone will have their own predefined level that they are comfortable with. Some might prefer a RRR ratio of 1.5 and above.

But a good rule of thumb is to avoid those that are below 1. It does not really make sense to risk $1 to potentially earn $0.60. We want our risk to be justified.

I hope this has helped you understand what the Risk Reward Ratio is all about.

What are your thoughts about RRR? Leave them in the comments below!

As always, happy trading.

Cheers.