The risk-reward ratio measures how much potential reward you stand to gain for every dollar you risk on a trade. It is calculated by dividing the distance between your entry and take profit by the distance between your entry and stop loss. A ratio of 1:3 means you are risking $1 to potentially make $3.

Professional traders typically require a minimum risk-reward ratio of 1:2 before entering a trade. This ensures that even if only half of their trades are winners, they still come out ahead over time. The formula is: Risk-Reward Ratio = (Take Profit - Entry Price) / (Entry Price - Stop Loss).

For example, if you enter a stock at $100 with a stop loss at $95 and a take profit at $115, your risk per share is $5 and your reward per share is $15, giving you a 1:3 risk-reward ratio. With 100 shares, you risk $500 to potentially gain $1,500. This favorable ratio means the trade only needs to succeed about one-third of the time to be profitable in the long run.