Risk to Reward Ratio

Many new traders think that a good entry into the markets is the key to success. Unfortunately, most are wrong. A trader must view each trade as a business transaction. A risk to reward ratio compares the potential for reward with the potential for loss. Risk is calculated by counting the pips between the forecasted entry price and the forecasted price at which you want to exit the market in case of a losing trade.

Reward is calculated by the pips between the forecasted entry price and the forecasted price at which you would want to exit the market in case of a winning trade. Reward is the expected number of pips that you want to make in a trade that will be a winner.

To manage risk properly, you need to look for high probability trades that have a risk to reward ratio of 1:2 or greater. This depends on the time frame that you want to trade. For example, if you are a day trader and you are looking for making only 30 pips in a trade, a stop loss of 15 pips is sufficient for the risk to reward ratio of 1:2.

However, if you are a swing trader or a position trader with a longer time frame, your profit potential will be more. If you choose 200 pips as your expected profit then you will need to set your stop loss at 100 pips.

The reason that you need to set a higher stop loss is that on a larger time frame, small trends occur within the larger trend. Retracements on shorter time frame is much smaller as compared on the larger time frame. Your trade is going to be recycled. In order to be not stopped out, you need to calculate your risk to reward ratio appropriately.

The second most important thing for traders is minimizing losses, next to maximizing profits. A forex trading system that wins on average only 50% of the time can still be profitable. Most of the traders want to make money. But they don't know how to protect what they currently have.

You have a 50/50 chance of the currency market going your way. It is just like flipping a coin. In case, the trade does not develop in your favor and the market is going against you, you should cut your losses by using stop losses. In simple terms, you cut your losses and let your winners run. This simple 50/50 trading strategy earns a profit even when a novice trader might experience a loss.

Consider different risk to reward ratios. How much you need to win to break even for each ratio? For a 2:1 risk to reward ratio, you need 67% winners to become profitable. For a 1:1 risk to reward ratio, it means just 50% winners to become profitable. 1:2 ratio means only 33.5% winners for profitability. Never ever trade when the risk to reward ratio is more than 1:2.