Experienced traders call the risk-reward ratio the Holy Grail of Forex. And if many investors would turn around when they come across such a term, Forex traders would think twice because the risk to reward ratio really increases their chances of profitability.
What is a risk-reward ratio?
In simple terms, it’s a calculation of how much you want to risk versus how much you want to earn. The risk is the amount you invest in a single trade, a sum you don’t mind losing because it has the potential to generate a reward. The reward is the amount you want to gain. Let’s use an example to put it better. You invest $1, so you can get another $1 once the trade ends. So, if the business is successful, you get $2. The first dollar is the risk, and the second is the reward. This simple principle also applies to Forex. But for a trade to be profitable, you want the compensation to exceed the risk. So, for the $1 you invest, you can choose to get another $1 or $3. The second is the obvious choice. In Forex, you can either lose or multiply your money.
When you hit the stop loss, you lose money, but when you hit the take profit, you earn some extra cash. We’ll use another example, to explain it. If for a trade you set the stop loss at 5 pips and the take profit at 20 pips, the risk-reward ratio is 5:20 and 1:4. You can get 20 pips if you risk 5.
How can you use a risk-reward ratio when trading currencies?
You probably figured out that the risk-reward ratio isn’t an indicator or system. It’s a smart application of the standard stop loss and take profit existent on trading platforms. The stop loss is the risk you are willing to make, and the take profit is the reward you hope to get. The basic principle behind this application is to find the opportunities that have a high premium. The higher the reward, the more failed investments you afford because you’re not losing money.
Let’s say that you invest according to the above scheme. One successful venture is buffering 4 unsuccessful trades that have an equal ratio. The principle behind this strategy is to find a profitable risk-reward ratio to complete a profitable business. If you stick with the 5:20 ratio, you afford to lose 50% of investments because you’ll still make enough profit.
What is the recommended risk-reward ratio?
You can achieve the 1:3 or 1:5 risk-reward ratio if the Forex market trends after forming a strong trade pattern and you manage to join it on time. Regularly, you hit both the top and bottom of a trend, at all time frames. It’s best to enter at the middle of the trade when the trend is more robust and allows you for extensive movements so that you can register 3 or 5 times higher profit than the SL.
This scenario is achievable, only that sometimes it encounters some issues.
– Forex markets trend in less than 30% of times
– Some trends are weak, and if traders enter with delay, or when the trend is past its half, they can register targets 3 or 5 times higher than the SL
– Often traders miss the opportunity to enter a profitable trade
Usually, traders hesitate to enter a business because they want to assess the risk, and they miss the chance. Sometimes they misinterpret trends, and they hit stop loss. So, the average investor loses in more trades before finding a profitable one.
And to answer the question of what is the recommended risk-reward ratio, experts would say the 1:2 because it maximizes the profits while limiting losses.
How to calculate risk and reward
The risk-reward calculation is one of the safest strategies Forex traders can use. Its calculation allows you to determine the risk and reward by dividing the net profit in relation to the maximum risk.
Keeping in mind that to calculate the risk-reward, you divide the reward by the maximum risk, let’s identify the main steps you must follow during the process.
1- Select the currency after exhaustive research
2- Check the current price to set the upside and downside targets
3- Register on a Forex platform to get a comparison of low spread Forex brokers
4- Calculate the risk-reward based on the above example
The ideal way to calculate the ratio is to use pips as a measure.
Risk-reward ratio = absolute value (Price entry value – stop loss value) / absolute value (Price entry value – target price value)
Let’s say you invest in the EUR/USD pair, for which the entry price is 1.3, the SL 1.2 and the target 1.5.
Entry price – stop-loss = 100 pips (the difference between 1.2 to 1.3)
Entry price – target price = 200 pips (the difference between 1.5 to 1.3)
In conclusion, the risk-reward ratio is 1:2, where 1 is the risk and 2 the reward.
How to use the risk-reward ratio when trading currencies
The principle behind this strategy is simple; you must identify the investments when the reward offsets the risk. As stated before, the higher the possible profit, the more unsuccessful trades your account can hold off.
The type of risk-reward ratio suitable for your account depends on your goals as a trader, and the Forex market conditions. It would be amazing to always find trades with high reward and low risk, but sadly the conditions on the Forex market are different. Markets are volatile; you set a stop loss to protect your account and capital and to stop the trade when it heads to a point you’d no longer afford. In some instances, the SL is different from the first market price or the safe exit. You, in the position of a trader, decide what risk-reward ratio suits your portfolio. It’s advisable to engage in no trade that has a risk higher than a reward, especially in your early days trading on the market.
The bottom line is that there is no general ratio that works for everyone. You pick the one that fits your market framework and investing style.
Image Source: Unsplash.com