The risk-reward ratio compares how much you are prepared to risk on a trade with the potential profit you hope to make. Commonly expressed as 1:2 or 1:3, it is a key part of risk management and position sizing in CFD trading.
Although the calculation appears straightforward on a price chart, many CFD traders overlook the true cost of opening and holding a position.
A theoretical 1:3 risk-reward ratio can become far less favourable once trading costs such as the spread (the small gap between the buy and sell price), commission (the fee your broker charges per trade), overnight fees (charges for holding a position open past the daily cut-off) and slippage are taken into account.
This guide explains how to calculate the risk-reward ratio more accurately, how real market conditions can affect your expected outcome, and why aiming for unrealistic profit targets can make consistent trading more difficult.
Quick Takeaways
- Your actual risk-reward ratio is often less favourable than it appears on a chart once the spread, commission, overnight fees and slippage are included.
- A stop-loss order does not guarantee your exact exit price. During periods of high volatility or market gaps, your actual loss may be greater than planned.
- There is no universally ideal risk-reward ratio. The right approach depends on your trading strategy, win rate and overall risk management.
- Targeting excessively high reward ratios can reduce the likelihood of reaching your profit target, which may affect long-term trading performance.
How to Calculate the Risk-Reward Ratio
The risk-reward ratio compares the distance between your entry price and stop-loss with the distance between your entry price and take-profit level.
To calculate it, divide the amount you could lose if the trade reaches your stop-loss by the amount you could gain if it reaches your profit target. This simple calculation helps you assess whether a trade offers a potential return that justifies the level of risk.
For example, suppose you open a stock CFD position with a stop-loss set £100 below your entry price. If your take-profit is £300 above your entry price, your potential loss is £100 and your potential gain is £300, giving you a risk-reward ratio of 1:3.
In other words, you are risking one unit to target a potential return of three. Likewise, risking £50 to target a £100 gain gives you a 1:2 risk-reward ratio.
Why Your Risk-Reward Ratio May Not Match Reality
A theoretical 1:3 risk-reward ratio shown on a chart rarely translates into a true 1:3 outcome once trading costs and market execution are taken into account.
Many trading guides present the risk-reward ratio as a simple mathematical calculation. In practice, however, the true cost of trading can reduce your potential returns while increasing your overall risk.
If you calculate a 1:2 setup using only the price levels on a chart, you may overlook the spread, broker commissions and any overnight fees charged for holding a leveraged CFD position beyond the daily cut-off.
Understanding what a stop loss is is only part of managing risk. A standard stop-loss order becomes a market order once the specified price is reached. If the market gaps over the weekend or moves sharply during periods of high volatility, the order may be filled at the next available price rather than your chosen level. This is known as slippage.
As a result, a planned £100 loss could become £150, making your actual risk-reward ratio less favourable than expected.
Many traders have experienced a trade coming within a fraction of its profit target before reversing and triggering their stop loss. In some cases, this happens because the spread widens around the daily market close or during periods of low liquidity, preventing the position from reaching the expected exit price.
What Is a "Good" Risk-Reward Ratio? (The Win Rate Connection)
There is no single perfect risk-reward ratio. The most suitable ratio depends on your trading strategy and, most importantly, your historical win rate.
Many traders ask whether a 1:3 risk-reward ratio is the benchmark for Forex trading. While ratios such as 1:2 and 1:3 are widely used, focusing on a single number can be misleading.
Your risk-reward ratio and win rate work together. A higher win rate may allow you to remain profitable with a lower risk-reward ratio, while a lower win rate generally requires a higher ratio to achieve the same long-term results.
The relationship becomes clearer when you look at the break-even maths. The lower your win rate, the larger your average winning trade needs to be to offset your losing trades.
It's also worth remembering that most retail CFD accounts lose money. Under FCA (Financial Conduct Authority) rules, CFD providers must disclose the percentage of retail client accounts that lose money when trading CFDs.
The exact figure varies by provider, but many report that between 74% and 89% of retail client accounts lose money when trading CFDs.
A poor understanding of the relationship between risk-reward ratios and win rates is one of several factors that can contribute to these outcomes.
Risk-Reward Ratio | Required Break-Even Win Rate |
|---|---|
1:1 | 50% |
1:2 | 33% |
1:3 | 25% |
1:4 | 20% |
1:5 |
Why Chasing High Risk-Reward Ratios Can Backfire
Targeting an excessively high risk-reward ratio can significantly reduce the likelihood of a trade reaching its profit target.
Understanding what is risk management in trading involves managing your emotions as well as your capital. One common mistake is trying to force a 1:5 or 1:10 risk-reward ratio simply because the potential return looks attractive.
In an attempt to recover previous losses or increase potential profits, some traders set a stop loss that is too tight while placing their take-profit level unrealistically far away.
The problem is that markets naturally fluctuate. A stop loss that is too close to the entry price may be triggered by normal market movements before the trade has a chance to develop.
Although the trade may appear to offer a 1:5 risk-reward ratio on paper, the strategy is unlikely to be profitable if the probability of reaching the profit target is too low.
For example, if your win rate falls to around 10% because your positions are repeatedly stopped out before the expected move occurs, your trading performance is likely to suffer over the long term.
Conclusion
The risk-reward ratio is a valuable tool for assessing potential trades, but it does not guarantee profitable outcomes. While a chart may show an ideal 1:3 risk-reward ratio, your actual result can be affected by the spread, broker commissions, overnight fees and slippage.
By taking the true cost of trading into account and using a risk-reward ratio that suits your trading strategy and historical win rate, you can make more informed decisions and build a more disciplined approach to risk management.
FAQ
Is a 1:3 Risk-Reward Ratio Always Profitable?
No. A 1:3 risk-reward ratio means you are targeting a potential profit that is three times greater than your potential loss. Whether it is profitable depends on factors such as your win rate, trading costs and market execution. If your win rate is too low or trading costs reduce your returns, a 1:3 ratio alone will not make a strategy profitable.
Can I Use a 1:1 Risk-Reward Ratio?
Yes. Many short-term trading strategies use a 1:1 risk-reward ratio. However, to break even before trading costs, you need a win rate of at least 50%. Once you include the spread, commissions and other trading costs, your required win rate becomes higher.
How Do Overnight Fees Affect My Potential Profit?
If you hold a leveraged CFD position beyond the daily cut-off, you may be charged an overnight fee. This cost is deducted from your account balance, which means your actual profit may be lower than your original risk-reward calculation.
What Is the Most Common Mistake Traders Make with Risk-Reward Ratios?
One common mistake is setting an unrealistically distant profit target while placing a stop loss too close to the entry price simply to achieve a higher risk-reward ratio. This can increase the likelihood of being stopped out by normal market movements before the trade has time to develop.
Does a Stop Loss Guarantee My Maximum Loss?
No. A standard stop-loss order becomes a market order once the specified price is reached. During periods of high volatility or after a market gap, the order may be executed at the next available price rather than your chosen level. This is known as slippage and can result in a larger loss than expected.