How to calculate the Risk Reward Ratio

Jaroslav Brychta, in his Morning Commentary, responded to a question about how to calculate the Risk Reward Ratio, where he mentioned his own experience and referred to a “gut feeling” - that intuition you have when deciding whether or not to open a trading or invest position.

The feeling Jaroslav described certainly works and will likely occur almost every time before you send an order to the market, even after calculating the RR or RRR.

If you open a trade based on this gut feeling and want to explain or understand it rationally, I call it “feeling that the probability of profit is on your side.” It’s intuition, but it arises from evaluating available information such as the fundamentals of the asset, the sector, market sentiment, charts, and similar factors, and it builds with experience. This applies equally to both investing and trading.

But let’s dive into this article and see if and how the Risk Reward ratio can actually be calculated.

How to calculate the Risk Reward Ratio

Of course, it is possible to calculate it, and it’s not complicated at all.

I would split it into two methods. However, the essential prerequisite is that the trade has clear exit targets for both profit and loss. Having a clear plan for both scenarios should always be a part of the consideration when taking a position.

The first method - Risk Reward Ratio

In this case, you take into account the invested or blocked amount (or margin), and for both exit scenarios (profit and loss), you calculate the potential gain and loss. For investing and trading, these values can differ significantly, so consider this example purely just to illustrate the calculation.

Let’s say your potential or target profit is $4,000, and you set your maximum loss at $600.

You divide both amounts: 600 / 4,000, and you get an RRR value of 0.15.

In other words, this means that for every dollar invested, you can gain $6.67 (1/0.15).

The second method - Risk Reward

The second method involves calculating a theoretical return in percentage terms and using that to assess or compare with other planned positions to decide whether opening a specific position makes sense.

In this case, you take the amount of investment or alocated margin and the expected or target profit over a certain period. For investing, this can be more difficult to estimate, but it forces you to have a clear goal and manage the position if it doesn’t develop according to the plan, potentially reallocating the investment to another position.

Options positions, for example, allow you to calculate this very precisely, so again, it depends on the strategy you’re using.

Let’s assume that you have a potential profit of $600 on $4,600 of blocked capital over 140 days. Your return would be 13% over 140 days, or 32.87% annualized.

These are two methods on how to calculate the Risk Reward Ratio values for different planned positions, allowing you to either compare them or simply determine if the resulting value meets your basic criteria for opening a position.

Afterward, you also need to evaluate the probability of achieving the profitable scenario which is what you’re aiming for - in other words, whether the probability of profit is on your side.

And then, just before you send the order to the market, you’ll feel that “gut instinct” Jaroslav mentioned…