Definition of the risk/reward ratio
The risk/reward ratio (written R/R or Risk/Reward) compares the potential gain of an investment to the maximum loss accepted. It is calculated before entering a position, from the purchase price, the stop loss and the price target.
Formula: R/R = Potential gain / Maximum risk = (Target price − Entry price) / (Entry price − Stop loss)
An R/R of 3:1 means you risk €1 to hope to gain €3. It is the benchmark ratio for most active investment strategies.
A concrete example: you buy a stock at €10. Your stop loss is at €9 (€1 of risk). Your price target is €13 (€3 of potential gain). R/R = 3:1. Even if only 1 trade in 3 is a winner, the strategy is profitable over the long run.
Interactive R/R calculator
Minimum hit rate by R/R
The hit rate (win rate) needed to be profitable depends directly on the R/R ratio. A favourable ratio lets you be profitable even with few winning trades:
| R/R ratio | Minimum hit rate | Interpretation |
|---|---|---|
| 1 : 1 | > 50% | Little margin — requires being right often |
| 1 : 2 | > 33% | Recommended minimum for an active strategy |
| 1 : 3 | > 25% | Benchmark ratio — very favourable mathematically |
| 1 : 4 | > 20% | Excellent — rare but very powerful when found |
| 1 : 5 | > 17% | Exceptional — typical of small-cap multi-baggers |
Break-even rate formula: Minimum win rate = 1 / (1 + R/R)
The Sharpe ratio: R/R at the portfolio level
The Sharpe ratio extends the R/R concept to the level of a whole portfolio. It measures the excess return (above the risk-free rate) obtained per unit of volatility borne.
Formula: Sharpe = (Portfolio return − Risk-free rate) / Standard deviation of returns
| Sharpe ratio | Interpretation |
|---|---|
| < 0 | Return below the risk-free rate — underperformance |
| 0 to 0.5 | Poor — risk badly rewarded |
| 0.5 to 1 | Adequate — in line with equity funds |
| 1 to 2 | Good — risk well rewarded |
| > 2 | Excellent — rare in practice over the long run |
Application to Euronext Growth small caps
For European small caps, the R/R ratio is built differently depending on the approach:
- Long-term fundamental approach: the "stop" is not a price but a fundamental invalidation (loss of a major contract, margin deterioration). The target is the estimated intrinsic value over 3-5 years.
- Mixed fundamental + technical approach: entry on a technical support, stop below that support, target at the next resistance. R/R calculable to the euro.
- Momentum screener approach: the BUY signal of Screener Small Caps identifies the stocks with the best upside/risk profile over the 3 horizons (D+30, D+60, D+90).
The ML model of Screener Small Caps selects the European small caps with the best ratio of outperformance potential vs downside risk over 3 horizons.