Understand risk-reward ratio (minimum 1 - 2) — Stock-Market notes

WHAT is it?

Risk (per share) = distance from entry to stop-loss.
Reward (per share) = distance from entry to target.

WHY does 1:2 matter? (derive the break-even truth from scratch)

Suppose over many trades your win rate is $W$ (fraction of trades that hit target) and every winner pays $R$ times what a loser costs. Set the loss per trade $=1$ unit.

Expected profit per trade (expectancy): $E = W\cdot R - (1-W)\cdot 1$

Why this formula? Winners happen fraction $W$ of the time and each gains $R$ ; losers happen fraction $(1-W)$ and each loses $1$ . Add them up weighted by probability — that's the average outcome.

Break-even is where $E = 0$ : $W\cdot R - (1-W) = 0 \;\Rightarrow\; W(R+1) = 1 \;\Rightarrow\; \boxed{W_{\text{be}} = \frac{1}{R+1}}$

HOW to compute and use it

Figure — Understand risk-reward ratio (minimum 1 - 2)

Worked Examples

Common Mistakes (Steel-man + Fix)

Recall Feynman: explain to a 12-year-old

Imagine a coin-flip game. If you lose you pay ₹1, but if you win you get ₹2. Even if the coin is a bit unlucky for you and you only win 4 times out of 10, you still end up richer, because those 4 wins (₹8) beat those 6 losses (₹6). Risk–reward 1:2 is choosing to play only games where the prize is at least double the price. That way you can be wrong a lot and still win overall.

Flashcards

What is the risk–reward ratio formula?

\dfrac{|\text{Entry}-\text{Stop}|}{|\text{Target}-\text{Entry}|}

, i.e. risk per share ÷ reward per share.

What does "minimum 1:2" mean?

Reward is at least twice the risk;

R \ge 2

Break-even win rate for reward multiple R?

W_{be}=\dfrac{1}{R+1}

Break-even win rate for a 1:2 trade?

1/3 \approx 33.3\%

Break-even win rate for a 1:1 trade?

50%.

Expectancy formula per trade (loss = 1 unit)?

E = WR-(1-W)

Entry 100, Stop 95, Target 110 → RRR?

Risk 5, Reward 10, so 1:2.

Why can a 1:2 system profit while losing 60% of trades?

Because winners pay 2× losers;

E=0.4(2)-0.6=+0.2>0

Why is win rate alone a misleading metric?

A high win rate with tiny reward vs large risk can still have negative expectancy.

Correct order: set target or check RRR first?

Set a logical target/stop first, then check RRR ≥ 2; never inflate the target to force the ratio.

Connections

Stop-Loss Placement — defines the risk side of the ratio.
Setting Price Targets — defines the reward side.
Position Sizing & the 1% Rule — converts RRR into share quantity.
Expectancy & Win Rate — the statistical justification for 1:2.
Support and Resistance — where logical targets/stops actually sit.
Trade Journaling — track realized RRR vs planned RRR.

Concept Map

Hinglish (regional understanding)

Intuition Hinglish mein samjho

Dekho, trading ek aisa game hai jahan har trade me tumhe do cheez pehle se decide karni hoti hai: agar galat hue to kitna lose karoge (risk = entry se stop-loss ki doori), aur agar sahi hue to kitna kamaoge (reward = entry se target ki doori). Risk–reward ratio bas inhi dono ka comparison hai. "Minimum 1:2" ka matlab — jitna risk lo, uska kam se kam double reward hona chahiye. Yaani ₹1 risk pe ₹2 ka target.

Ab iska asli magic yahan hai: agar tumhara reward risk ka double hai (R=2), to break-even ke liye tumhe sirf 3 me se 1 trade jeetna hai (33%). Formula hai $W_{be}=1/(R+1)$ . Iska matlab tum 60% trades haar bhi jao, phir bhi profit me reh sakte ho, kyunki tumhare winners chote losers ko easily beat kar dete hain. Isiliye pro traders win-rate ke peeche nahi bhaagte, wo expectancy dekhte hain: $E = WR-(1-W)$ .

Ek common galti — log target ko zabardasti door kheench dete hain taaki ratio 1:2 dikhe. Ye trap hai. Pehle logical target lagao (resistance/support ke hisaab se), phir check karo ratio 2 se upar hai ya nahi. Agar nahi hai, to trade chhod do — market me aur bahut trades milenge. Discipline yahi hai: sirf wahi trades lo jahan paisa risk se kam se kam double ho.

Test yourself — Entry, Exit & Trade Management

Connections