Before entering any trade, an investor should ask two simple questions:
How much can I lose? And how much can I potentially make?
This is where Risk : Reward becomes important.
Risk : Reward helps us compare the potential loss from a trade with its potential gain. It does not predict whether a trade will be successful, but it helps us determine whether the potential reward justifies the risk we are taking.
How to Calculate Risk : Reward
Risk : Reward can be expressed as:
Risk : Reward = Potential Loss : Potential Gain
For example, if you are risking ₹10 to potentially make ₹25:
₹10 : ₹25 = 1 : 2.5
This means you are risking ₹1 to potentially make ₹2.50.
For equity trading, a Risk : Reward of 1:2.5 or better is often considered a desirable general guideline, given the relatively higher volatility and risk associated with equities.
However, 1:2.5 is not a rule. A favorable Risk : Reward alone does not make a trade attractive. The probability of reaching the target, the quality of the setup, and proper risk management are equally important.
Risk : Reward vs Probability
This is an important distinction.
Risk : Reward tells you how much you could potentially gain relative to what you are risking. Probability tells you how likely that outcome may be.
For example, a trade offering a 1:10 Risk : Reward may look extremely attractive, but if the target is very difficult to reach, the probability of success could be low.
Therefore, investors should consider both Risk : Reward and the probability of achieving the target rather than focusing only on the ratio.
A Case Study of Sheela Foam
Let’s understand the concept with the help of a technical example of Sheela Foam.
Chart Source : Moneycontrol
What Does the Chart Tell Us?
1. Triple-top formation
Sheela Foam formed a potential triple-top pattern around the ₹830 level (See Red Arrow in the chart above).
On July 13, August 4 and August 5, the stock attempted to cross and sustain above ₹830 but failed, indicating that ₹830 was acting as a strong resistance zone.
2. Breakdown below support
Following the June 26 quarterly results, the stock witnessed profit booking and subsequently broke below the ₹730–₹735 support zone.
This zone had been tested around July 2, July 8 and July 22 (See Blue Arrow in the chart above).
The breakdown occurred on higher trading volume, suggesting that selling pressure was increasing.
When a stock breaks an important support level on higher volume, it can indicate that more market participants are willing to sell at lower prices.
3. Double-bottom formation
After the breakdown, the stock tested a low of approximately ₹662 twice, on August 10 and August 18, forming a potential double-bottom pattern (See Green arrow in the chart above).
Interestingly, these tests occurred on declining volumes, suggesting that selling pressure was weakening.
The stock also remained just above its 200-Day Moving Average (DMA) of ₹655.99, providing another technical reference point.
Now Let’s Calculate the Risk
Suppose an investor considers a hypothetical entry price of approximately ₹666.
A stop-loss (SL) is placed at ₹660, below the ₹662 double-bottom support.
Therefore:
Entry Price = ₹666
Stop-Loss = ₹660
Potential Risk = ₹666 − ₹660 = ₹6 per share
In simple terms:
You are risking ₹6 per share.
The next question is:
How much could you potentially make?
Potential Rewards
| Target | Target Price | Potential Gain | Why This Target? | Risk : Reward |
|---|---|---|---|---|
| Target 1 | ₹717 | ₹51 | Previous relief-rally high of ₹717 made on August 12 | 1 : 8.5 |
| Target 2 | ₹735 | ₹69 | Previous ₹730–₹735 support zone, which could now act as resistance | 1 : 11.5 |
| Target 3 | ₹832 | ₹166 | Previous resistance zone around ₹830–₹832 | 1 : 27.7 |
Why can previous support become resistance?
The earlier ₹730–₹735 level acted as support. After the stock broke below it, this same zone may become resistance.
One reason is that investors who bought around this level may look to exit when the price returns to their purchase zone, creating additional selling pressure.
Putting It All Together
Target 1
The ₹6 → ₹51 → 1:8.5 Story
🔵 Entry: ₹666
🔴 Stop-Loss: ₹660
🎯 Target 1: ₹717
Potential Risk:
₹666 − ₹660 = ₹6
Potential Gain:
₹717 − ₹666 = ₹51
Therefore:
₹6 Risk → ₹51 Potential Reward
₹6 : ₹51 = 1 : 8.5
In simple terms:
For every ₹1 being risked, there is a potential reward of ₹8.50.
This is the essence of Risk : Reward.
Target 2
Potential gain = ₹735 − ₹666 = ₹69
Therefore:
₹6 : ₹69 = 1 : 11.5
You are risking ₹1 to potentially make ₹11.50.
Target 3
Potential gain = ₹832 − ₹666 = ₹166
Therefore:
₹6 : ₹166 = 1 : 27.7
You are risking ₹1 to potentially make ₹27.70.
What Does This Tell Us?
Based purely on the hypothetical entry, stop-loss and targets, the setup offers a potentially favorable Risk : Reward profile.
However, there is an important point to remember:
A higher Risk : Reward does not necessarily mean a better trade.
Target 3 offers a very attractive 1:27.7 Risk : Reward, but it is considerably farther away and may therefore have a lower probability of being achieved than Target 1.
The purpose of Risk : Reward analysis is not to predict the future with certainty.
It is to ensure that:
The potential reward is sufficiently large relative to the amount being risked.
So, don’t simply look for the highest Risk : Reward ratio.
Instead, consider:
Risk + Reward + Probability
A realistic target with a reasonable probability of achievement can be more useful than an extremely distant target with a very low probability of being reached.
Key Takeaway
Before entering a trade, don’t just ask:
“How much can I make?”
Also ask:
“How much can I lose if I am wrong?”
In this example, the hypothetical trade risks ₹6 per share for a potential gain of ₹51 at Target 1, resulting in a 1:8.5 Risk : Reward.
That is significantly better than the commonly used 1:2 or 1:2.5 guideline.
But remember:
Risk : Reward is only one part of the decision-making process.
A sound trading setup should ideally combine:
- A clearly defined entry
- A logical stop-loss
- Realistic price targets
- Favorable Risk : Reward
- A reasonable probability of achieving the target
- Disciplined execution
The objective is not simply to find trades with the highest Risk : Reward. It is to find trades where the potential reward, probability and risk are reasonably aligned.
Disclaimer
This illustration is intended solely to explain the concept of Risk : Reward using a technical example. It should not be considered a stock recommendation or investment advice. Readers should conduct their own research and due diligence and consider their individual risk appetite before making any investment decisions.
Disclosure
The author holds a position in Sheela Foam and therefore has a financial interest in the stock discussed in this article.
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