You know about risk
from your day to day life. What move is risky, what move isn’t. Most of your decision are probably based on the amount of risk that you’re willing to endure. If the risk-reward ratio is low, you’ll most likely go for it.
Such is the case with forex trading. Traders are constantly on the lookout for low risk-reward ratios. But then again, the risk you’re willing to put upon yourself is very worth the reward!
In this article, we’ll go over what exactly that ratio is, how to calculate it, and when to decide what move is worth the risk.
So buckle up, and let’s get started.
How much are YOU willing to risk?
The choice of a risk-reward ratio is almost exclusively up to the trader. We've already covered some strategies for successful trading
, but we've yet to cover the risks involved, and that's why we're writing this!
There isn’t the best ratio out there that suits everyone. Although, in general, 1:2 risk reward ratio is considered somewhat a commonly used ratio.
It all comes down to how much a trader is willing to put on the line. The 1:2 ratio which we just mentioned will maximise profits, while still keeping the losses to a bearable amount if the trade goes sideways.
The nice thing about this ratio, for instance, is that you only need one winning trade, to cover to lost ones.
Let’s put it in an example, so you get a better idea of what we mean.
So, let’s say you risk 50 pips in order to win 100. You win that first trade. But in the next two, you lose. By winning the first one, you gained a 100. While losing 50 each time you lost. So now, you’re back to square one, which isn’t that bad, if we’re honest.
Let’s make an example now with some bigger numbers, shall we?
You do 20 trades. Each of them have a 1:2 risk reward ratio.
You win 8 trades, but you lose the rest. Well, that’s a letdown, isn’t it?
Actually, it isn’t, and we’ll get into why it isn’t right now.
From the 1:2 ratio, we can establish that you’ll win twice as much if you were to lose. With that in mind, let’s put one losing trade at a $100.
So you’ve lost a $100 a total of 12 times, making that $1200. But you’ve won 8 times. With the winning amount being $200. If you do the math on that, it comes up to $1600.
Congratulations, you’ve won $400 of clean net profit.
What is a Pip?
In forex, you’ll encounter some new term which you’ve most likely haven’t heard before.
These might include „pips“, pipettes“, „lots“ and so on.
The term Pip is, in fact, a unit of measurement. It’s used to express how much the value between the two currencies has changed. Pip is actually an abbreviation for percentage in points.
If for example EUR/GBP is at 0.8866, and it changes to 0.8867, that change is value is ONE PIP.
Almost all pairs go out to four decimal places, but some, like the Yen, are exceptions and they go out to two decimal places.
A pipette is that, just smaller?
You’d be exactly right!
Some brokers quote currency pairs to five, or three decimal places, respectively.
Those are interpreted as pipettes or fractional pips.
Why have we gone over the trading terms just now?
Because all of this risk-reward or reward-risk ratios are measured in pips, so, we just want to keep everyone prepared, how nice of us.
Final thoughts and tips
On the surface, the concept of putting a high reward-to-risk ratio sounds good, but before doing that, think about how it applies in the real world. In the real world, ratios are not concrete; they’re subject to changes. Considering the exchange rates can move a few pips in either direction within a few seconds, the ratios would have to be adjusted depending on the circumstances. Those include the trading environment, time frame, and your entry/exit points.
Whatever the case may be, you will need to practice how you would react to those pressures, and if the changes you would make would affect the outcome accordingly.