Today I want to talk about risk reward ratio in forex trading. You may have heard about risk reward ratio already, but what is risk reward ratio?
Hi friends! Today I want to talk about risk reward ratio in forex trading.
You may have heard about risk reward ratio already, but what is risk reward ratio?
Risk reward ratio is a ratio used by many investors/traders to compare the expected returns of an investment to the amount of risk undertaken to capture these returns.
This ratio is calculated mathematically by dividing the amount traders stand to lose if the price moves in the unexpected direction (i.e., the risk) by the profit the trader expects to have made when the position is closed (i.e. the reward).
What Is Risk Reward Ratio?
The risk-reward ratio is a concept commonly used in forex trading and other financial markets to assess the potential profitability of trading relative to the potential loss. It is a way to evaluate the relationship between the risk taken on trade and the potential reward or profit that can be gained.
The risk-reward ratio is typically expressed as a ratio or a multiple, comparing the amount of risk (in terms of potential loss) to the potential reward (in terms of potential profit).
For example, a risk-reward ratio of 1:2 means that you expect to gain two units of reward for every unit of risk you take. Similarly, a risk-reward ratio of 1:1 would mean that the potential reward equals the potential risk.
Traders use the risk-reward ratio to help determine whether a trade is worth taking. By analyzing the potential profit and loss levels, traders can assess whether the potential reward justifies the risk. A higher risk-reward ratio indicates that the potential reward is greater than the potential risk, which can be seen as a favorable trade setup.
Examples of Using Risk Reward Ratio
So let me explain more about risk reward ratio.
Let's say you want to enter a trade on EUR/USD. You use a 0.1 lot with 30 pips stop loss and 60 pips profit target. The ratio of your risk (from stop loss) and reward (from profit target) is 1:2 (30:60) which you trade with double the amount that you risk. The risk reward ratio will be different between traders. Based on trading strategies and the market's situations, risk reward ratio of every trade will not always be the same.
As a forex trader, I still struggle to follow a good risk reward ratio. I usually trade with 1:1 risk reward ratio, which is the standard risk reward ratio in trading. In my opinion, 1:1 risk reward ratio is not that good if you don't have a really good trading strategy.
Let me give you some examples:
You have a trading strategy that has a 60% winning rate. You are using a 1:1 risk reward ratio in every trade you make. Let's say you trade 20 trades in a month with 20pips of stop loss and profit target.
How many pips will you get at the end of the month?
60% winning rate from 20 trades = 12 winning trades (8 losing trades)
(12 winning trades x 20 pips ) - (8 lose trades x 20 pips) = 240 pips - 160 pips = 80 pips
So at the end of the month, you will get 80 pips of profit. It's pretty good. But that's IF you have a 60% winning rate strategy. So what if you have only a less than 50% winning rate?
The answer is to increase your reward ratio.
Let's say you only have a 40% winning rate. You are using a 1:3 risk reward ratio, with 20 pips stop loss and 60 pips profit target. How many pips will you get at the end of the month?
40% winning rate from 20 trades = 8 winning trades (12 losing trades)
(8 winning trades x 60 pips) - (12 lose trades x 20 pips) = 480 pips - 240 pips = 240 pips
Even though you use a 40% winning rate strategy, you can still make money! I think people are wrong in talking about how high your winning rate percentage is. The calculation above proves that even a 40% winning rate can make money.
So that's up to you now.
I have to admit that I am not always using a more significant reward ratio, and sometimes struggle to use a 1:3 risk reward ratio (or even bigger) but I want to show you that winning rate is not everything. An excellent winning rate with a good risk reward ratio plus proper money management will make you successful in Forex trading.
I hope this article will help you. Let's become better forex traders!