As we have established so far in these lessons, each trade taken in the foreign exchange market is associated with the risk of losing a specified amount of capital, and making a positive profit which helps us grow our account balance. The relationship between the 2 sides of this ‘penny’ is commonly referred to as the risk to reward ratio, often abbreviated to RR. The risk:reward ratio is the ratio between the sum of money risked on a single trade and the potential reward that this trade might provide. If we are placing a trade in which we risk €300 to make €600, the risk:reward ratio is 1:2. This ratio can also be derived by using the pips and percentages which correspond to a particular trade. If our stoploss on a trade is 25 pips and our target is 100 pips, the risk:reward is 1:4. Assuming we risked 1% on this same trade, we will gain 4% if our analysis plays out as forecasted and the price reaches our takeprofit.
The risk to reward ratio is an extremely impactful factor on a trader’s performance. Aiming to gain a high reward from one unit of risk, gives us as traders more room for losses. Let’s use a few examples from the table below to gain further insight into this idea. We will assume our risk:reward ratio is fixed for each order we execute on the market. If our losses are equal to our wins in terms of capital, winning half of our trades and losing the other will result in breaking even. With a 1:1 RR we would need to win more than half of our trades to at least be profitable. As the RR increases, the accuracy required to be profitable declines. We must however acknowledge that trades with a high RR are less probable, and more challenging to capture, but they are worthwhile. Having a larger margin of error empowers a trader and helps him remain calmer through tough times. In a hypothetical scenario where a trader suffers a losing streak of five trades, he would only need one 1:5 RR trade to recover his deficit. Contrastingly, a trader with a 1:1 RR system would need to win 5 trades consecutively just to break even. Through these examples we can conclude that following a high risk:reward system is beneficial for a trader, both mentally and monetarily.
|Risk to reward ratio
|Accuracy required for profitability