What is a 'Risk/Reward Ratio'
Many investors use a risk/reward ratio to compare the expected returns of an investment with the amount of risk undertaken to capture these returns. This ratio is calculated mathematically by dividing the amount the individual stands to lose if the price of an asset moves in the unexpected direction (the risk) by the amount of profit the trader expects to have made when the position is closed (the reward).
The risk/reward ratio is often used as a measure when trading individual stocks. The optimal risk/reward ratio differs widely among various trading strategies. Some trial and error is usually required to determine which ratio is best for a given trading strategy, and many investors have a pre-specified risk/reward ratio for their investments. In many cases, market strategists find the ideal risk/reward ratio for their investments to be approximately 1:3, or three units of expected return for every one unit of additional risk. Investors can manage risk/reward more directly through the use of stop-loss orders and derivatives such as put options.
