A trader should see the forex market as a business. There are 2 main goals when it comes to running a business: 1 – Not to lose money & 2 – To make money. The same can be said for trading forex. A trader’s first priority is not losing money (preserving capital); the trader’s second priority is making money (building on their capital).
Every trade carries an element of risk. Good traders know that managing risk is their most important concern; however many novice traders go down the other road and become more concerned with their potential rewards giving little regard to their risk.
When successful traders identify potential trade set ups the first thing they do is calculate their risk, they work out the safest place to put their stop loss. They know the market never moves in a straight line and always give their trades space to breathe. The next thing they do is work out their potential reward. They don’t randomly place or go for unrealistic targets. They analyze the current market and decide upon what area they will be targeting. If they feel there is no realistic target available they will NOT take the trade. Their target will always be a minimum 2x the size of their risk. (i.e. if they risk $50, their target will be a minimum of $100).
The Ratio –
A Risk Reward ratio is the ratio between a trade’s risk and a trade’s reward. Commonly, the ratios are written in the follow way – 1:3, this means the reward is 3x the size of the risk. The first part of the ratio will always be 1, with the second part usually being 2 or more.
1:3
Risk : Reward
Risk : Reward can be measured in a number of ways. Each part of the ratio can either be: a number of pips, amount in money or as a percentage.
For example:
If we are taking a trade with a stop loss of 50 pips targeting 150pips, our R:R ratio is 1:3.
If we are taking a trade with a stop loss of $50, targeting $150, our R:R ratio is 1:3.
If we are taking a trade risking 2% of our account, aiming to grow our account by 6%, our R:R ratio is 1:3.
The reward part of the ratio can be whatever the trader decides, as minimum most professional traders will be targeting at least 2x what they risk, usually a lot more. It is not uncommon for longer term trades to have a R : R of 1 : 5 / 6 / 7 etc…
Using a good Ratio has a number of benefits. The first and probably most important being R:R ratios help eliminate emotional trading. The second being they allow you to reduce your ‘win rate’ and still be profitable in the long run.
Below you can see the difference and benefits of using a higher R:R ratio compared to a low R:R ratio. Each scenario is based on the risk amounting to $100, 10 trades being taken with 5 winners and 5 losers.
| R:R 1:3
| |
| Trade | Loss | Win |
| 1 | 300 | |
| 2 | 100 | |
| 3 | 100 | |
| 4 | 300 | |
| 5 | 300 | |
| 6 | 100 | |
| 7 | 300 | |
| 8 | 100 | |
| 9 | 100 | |
| 10 | 300 | |
| Total | 500 | 1500 |
| Total Profit | 1000 | |
You can see above using a 1:3 Risk : Reward ratio obviously works out very well. We only need to win 50% of our trades to bring home a handsome profit. Every losing trade is worth $100; every winning trade is worth $300. It’s clear to see 1 winner greatly outweighs 1 loser meaning we can afford to lose 5 trades and only need to win 2 to make a profit.
| R:R 1:2
| ||
| Trade | Loss | Win |
| 1 | 100 | |
| 2 | 200 | |
| 3 | 200 | |
| 4 | 100 | |
| 5 | 100 | |
| 6 | 100 | |
| 7 | 200 | |
| 8 | 100 | |
| 9 | 200 | |
| 10 | 200 | |
| Total | 500 | 1000 |
| Total Profit | 500 |
You can see above using a 1:2 Risk : Reward ratio again works out well, however not as well as the 1:3 mentioned above. This time, we are targeting 2x what we have risked. Every losing trade is worth $100; ever winning trade is worth $300. its clear to see 1 winner greatly outweighs 1 loser meaning we can afford to lose 5 trades and only need to win 3 to make a profit.
| R:R 1:1
| ||
| Trade | Loss | Win |
| 1 | 100 | |
| 2 | 100 | |
| 3 | 100 | |
| 4 | 100 | |
| 5 | 100 | |
| 6 | 100 | |
| 7 | 100 | |
| 8 | 100 | |
| 9 | 100 | |
| 10 | 100 | |
| 500 | 500 | |
| Total Profit | 0 | |
Using the 1:1 Risk : Reward ratio does not work out as well as using a 1:2 or 1:3 as mentioned above. This time we are targeting the same as what we are risking meaning ever loss will be felt the same as every win. In this case our percentage of winning trades needs to be higher if we want to make a profit. If we lose 5 trades we need to win 6 trades to make a profit.
| R:R 1:0.5
| ||
| Trade | Loss | Win |
| 1 | 100 | |
| 2 | 50 | |
| 3 | 100 | |
| 4 | 100 | |
| 5 | 50 | |
| 6 | 50 | |
| 7 | 50 | |
| 8 | 100 | |
| 9 | 100 | |
| 10 | 50 | |
| Total | 500 | 250 |
| Total Profit | -250 | |
The R : R of 1:0.5 does not work well after our 10 trades. This time our target is half of what we are risking. Ever losing trade is worth $100 with ever winning trade being worth $50. Its clear to see we that if we lose 1 trade we need to win 2 just to get back to breakeven. We would need to win 3 trades in order to turn a profit meaning our percentage of winning trades needs to be very high which can be difficult to achieve.
Using good R : R ratios are of paramount importance when trading forex. A high ratio allows the trader ‘breathing space’ with their win rate, we can win fewer trades and still make a handsome profit. Low R:R ratios mean the trader needs to have a high success rate of winning trades which we know is very difficult to achieve (despite people claiming 90%+). Its important to remember every trade carries an element of risk and as a trader you are a Risk Manager. Your first and most important job as a trader is to MANAGE YOUR RISK.
