Forex Trading – Risk-Reward Ratio Explained
July 11th, 2009
From the very beginning of your forex career a term Risk/Reward Ratio will be an important part of your trading strategy. The realization that every single trade you make contains a certain degree of risk will defend you from uncontrollable fears and panic attacks during the trading hours. This is when the risk management comes in handy. The best known way to figure out the risk you take is to calculate the risk-reward ratio. What is this ratio and how is it determined?
The Risk-Reward ratio is a trading factor that shows the level of possible risk in a selected trade. It shows the amount you can possible lose versus the potential profit. Some forex traders prefer to ignore the calculation of risk-reward ration, but only find themselves with great and unnecessary losses.
Some forex traders preach that a successful trader needs to risk a lot in order to win large. In my opinion, this is not true and the best way to succeed in forex trading is to not risk everything you have got. Forex is not a guessing game, not a twirl of luck in a casino and definitely not a lottery ticket. Every trade consists of probability of winning and losing and therefore only a good strategy will reward you will profits.
Reward
The reward is of course closely related to the profits you hope t make from the price movements. The formula to figure out the reward is as follow:
the gain multiplied times the amount of lots traded
Risk
First thing to do when calculating the risk-reward ratio is to figure out the risk itself. This can be done by analyzing the total sum of money needed to enter the trade. The actual amount of money at risk is calculated by the following formula:
the price of the selected currency multiplied times the amount of lots
Now that you have two numbers on your hand, it is easy to find out the ratio. For example:
IF Risk = $200 and Reward = $500 THEN the risk-reward ratio is 200:500 or, a shorter version, 2:5
IF Risk = $1,000 and Reward = $200 THEN the risk-reward ratio is 1000:200 or 5:1
In forex market it is advisable not to bet huge amounts on a position, simply because you put your investment in danger. It is statistically proven that a successful trader doesn’t put anything larger than 10% of their funding on a trade. In case you do place more than 10%, you risk losing quite a piece of your money. And that is not all – you might blow your whole account up and therefore lose the ability to invest in other trades.
The best way is to analyze the possible risks and rewards with the selected currency pair. The ratio is important for your success and the excepted good ratio is minimum 1:2. The risk-reward ratio of 1:2 means that for every dollar you invest will bring 2 dollars back in profits. Your agenda is to analyze which trades will earn you more than the amount you invest.
What about larger ratio? An acceptable risk-reward ratio for beginners is 1:3. Trades that should be avoided at all costs are the ones with the risk-reward ratio of 1:1 or when the risk is larger than the reward.
Once you gain some experience, you can experiment on trades with ratio of 1:5 and higher. High risk-reward ratio can turn out to be very profitable if the currency doesn’t make any unexpected price movement.
Overall, the risk-reward ratio is very important for your trading success. The calculations might take up time, but it will minimize the risk in every trade you enter. Also, waiting for higher risk-reward ratio can turn out to be worth the patience.
With risk-reward ratio you will know whether the investment in each trade will pay off. Forex trading is business and you have to know the risks and the potential wins. The strategy makes a successful trader.
In the beginning you might not have a strategy of your own or you might not have developed one yet and therefore relay on daily signals received from a broker or a signal provider. If the signal services provided are legitimate, in most cases the tips are profitable.
However, you might notice at some point in your trading life that the trades your broker or the signal provider suggests has a greater Loss value than Win. For example, on the actual trade the pip profit is 150 while the pip loss is 310. Doesn’t this ruin the whole idea of not placing a trade when the risk-reward ratio is “against” you?
Here is the trick. The signal providers often apply a large stop loss to take small gains. The reason they do so, is of course the security. This way, the provided gets a high number of winning trades. You can check this by placing opposite trades in your demo account and observe the results after a few months. This will show you if the signal provider or your forex broker uses the trick!
Signal services have a different market strategy and agenda and therefore it is sometimes difficult to figure out if the stops and targets they suggest are truly meaningful. On the other hand, it does help in most cases while looking at charts.
In my opinion though, eventually you have to come up with a strategy of your own. This often takes time until you understand what kind of strategy suits you best, how often you can trade, how much free time do you have available for forex trading, what is your financial situation and the attitude towards risks, money management etc. I say, trade with demo account, use the signals received from your forex broker or signal provider to get some practice with the charts. Once you develop your strategy forex trading will be as easy as falling off the log.
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