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Risk/Reward Positions

The risk/reward ratio marks the prospective reward an investor can earn, for every dollar he or she risks on an investment. Many investors use risk/reward ratios to compare the expected returns of an investment with the amount of risk they must undertake to earn these returns. Consider the following example: an investment with a risk reward ratio of 1:7 suggests that an investor is willing to risk $1, for the prospect of earning $7. Alternatively, a risk/reward ratio of 1:3 signals that an investor should expect to invest $1, for the prospect of earning $3 on his investment.

Traders often use this approach to plan which trades to take, and the ratio is calculated by dividing the amount a trader stands to lose if the price of an asset moves in an unexpected direction (the risk) by the amount of profit the trader expects to have made when the position is closed the reward…