What it is
The risk-reward ratio compares what a trade stands to make against what it stands to lose, measured from the entry to the target and from the entry to the stop. Quoted as 1:2, or as two R, it is the unit in which most traders describe an individual position.
How it works
The calculation is (target - entry) / (entry - stop) for a long. Its usefulness comes from pairing it with a hit rate: the break-even win rate for a ratio R is 1 / (1 + R), so a 1:2 trade needs to work only about 34 percent of the time, while a 1:0.5 trade needs 67 percent. Expectancy per trade is win rate times average win minus loss rate times average loss, and that single number, not the ratio alone, determines whether a strategy makes money.
How traders use it
Used well, the ratio is a filter and a planning device. If the nearest sensible target is closer than the nearest sensible stop, the trade is asking a great deal of the hit rate and can simply be skipped. It also forces both the stop and the target to be defined before entry, which is where most of its behavioural value comes from.
Where it breaks down
The planned ratio is not the realised one. Targets are reached less often than stops because stops sit closer to price, partial exits change the arithmetic, and slippage falls harder on the loss side. Quoting a headline ratio without the corresponding win rate is meaningless: a strategy advertising 1:5 with a 12 percent hit rate loses money. Measure the distribution of realised R across a large sample instead of trusting the plan.
Educational reference. This entry describes how a concept is defined and used. It is not investment advice, not a recommendation, and not a signal. Any rule you build from it should be tested with realistic costs before it is traded, and no historical result guarantees a future one.