Forex is a game of probabilities.
That’s the fact!
Forex traders who see trade setups in terms of risk to reward ratio are the ones who make consistent money in the forex market.
Again, to develop your discretionary trading skills, you must have a sharpened sense for spotting well defined trade setups at the right time and place.
It is a necessary ingredient to successful trading.
However, you can still make consistent money on Forex even if you’ve not fully matured your discretionary trade setup identification skills.
The risk to reward setups give all traders an equal chance to make money consistently.
This means that understanding the risk to reward ratio and how to see trade setups in terms of possible risk to possible reward is crucial for successful trading.
It is second to having emotional control and a proper amount of self-discipline.
In this article, I will be discussing the risk to reward ratio to help you know how to use it correctly…
Let’s start!
What is the Risk:Reward Ratio?
The risk:reward ratio defines the prospective reward that an investor can earn for each dollar he risks on an investment.
Traders use the risk:reward ratio to compare the expected returns for an investment with the amount of risk that they must undertake in order to earn those returns.
For example, an investment with a risk:reward ratio of 1:6 means that the investor is willing to risk $1 to earn $6.
Also, a risk/reward ratio of 1:4 means that the investor is willing to risk $1 to earn $4.
Traders use this approach to decide which trades to take and which ones to avoid.
Myths about Risk:Reward Ratio
Some traders have believed some myths about the risk:reward ratio, and this has cost them some dollars.
So, let’s discuss some of the misconceptions about the risk:reward ratio…
#1: The risk:reward ratio is useless
You must have heard from some traders that the risk:reward ratio is useless, and this can’t be further from the truth.
When you combine the risk:reward ratio with other trading metrics like the winrate, it becomes a powerful trading tool.
If you don’t know the risk:reward ratio for a single trade, it’s impossible for you to trade profitably.
Consider the following chart that shows the power of combining the risk:reward ratio with the winrate…
From the above chart, you can tell where profitable trading is after combining the risk:reward ratio and the winrate.
You will make the most profits when the two are very high.
If the two are low, you will make no profit.
If one of them is low and the other one high, you will make a considerable amount of profit.
If you want to become a successful Forex trader, make sure you combine the two!
Some traders believe that they need a risk:reward ratio of not less than 1:2 to trade successfully.
It’s a lie!
The reason is that the risk:reward ratio is not useful on its own.
Let me give you an example to demonstrate this…
Let’s say you’re trading with a risk:reward ratio of 1:2.
This means you make $2 for each trade that you win.
Your winrate is 20%.
This means that for every 10 trades, you have 8 losing trades and 2 winners.
So,
Your total loss = $1 x 8 = -$8
Your total gain = $2 x 2 = $4
Your net loss = -$4
What does it tell you?
That the risk:reward ratio means nothing on its own.
So, always combine the risk:reward rate with the winrate to know whether you will make money in the long run or not!
#2: “Good” vs. “Bad” risk:reward ratio
You must have heard some traders talk about generic and arbitrarily chosen minimum risk:reward ratio.
You might have read from books that you should have a risk:reward ratio of at least 2:1, especially if you don’t know any other trading parameter.
However, here is the fact….
There is no good or bad risk:reward ratio.
What matters is how you use it.
It’s possible for you to trade profitably even with a risk:ratio of 1:1 or even less.
#3: A high risk:reward ratio doesn’t make bad trades better
Many are the times traders think of using a closer stop loss or a wider profit target to increase their risk:reward ratio and improve their trading performance.
However, it’s not easy as you think.
When you use a wider take profit order, it means that the price will not be able to reach the take profit order easily and the winrate will decline.
On the other hand, if you set your stop loss closer, you will increase premature stop runs.
This means that there will be high chances of you being kicked out of trades when it’s too early.
Most newbie traders tend to justify “bad” trades with a larger risk:reward ratio.
Always remember to stick to your trading rules.
Again, hoping to achieve a larger risk:reward ratio does not suddenly make a bad trade acceptable.
How to Find your Edge
As we’ve stated, the risk:reward ratio alone isn’t enough.
You will see this in the formula that we’re about to use…
To know your edge, use the following formula…
E= [1+ (W/L)] x P – 1
Where,
W is the size of your average winL is the size of your average lossP is your winning rate
Let me give you an example…
Let’s say you made 10 trades, 6 winning and 4 losing.
From this, your percentage win ratio is 6/10 or 60%.
If from the 6 winners you made $3600, then your average win is $3600/6 = $600.
If your 4 losers were $1600, it means your average loss is $1600/4 = $400.
We can then apply the above figures to the expectancy formula…
E= [1+ (600/400)] x 0.6 – 1 = 0.5 or 50%.
This means that the expectancy of your trading strategy is 50%, which is a positive expectancy.
This can be interpreted as, the trading strategy will return 50 cents for each dollar you trade in the long term.
This means that it’s a lie to believe that you should have a risk:reward ratio of at least 1:2.
The reason is that you can have a risk:reward ratio of 1:0.5, and if your winrate is high enough, you’ll still make profit in the long run.
This means that when trading, the most important metric is neither risk:reward ratio nor winning rate.
It is your expectancy!
How to Set the Stop Loss
Of course, you should not place your stop loss at an arbitrary level.
It makes no sense.
Instead, you should lean against the structure of the markets that acts as a barrier, preventing the price from hitting your stops.
Examples of such market structures include Trendlines, Support and Resistance, and Moving average.
Next, your position sizing must be correct to avoid losing a huge chunk of capital in case you get stopped.
You can use the formula given below…
Position size = Amount to risk / (stop loss * value per pip)
Let’s say…
You want to risk $50 per trade.
Your stop loss is 200 pips.
Each pip has a value of $10. Note that this value is determined by the currency you’re using.
We can then insert the above values in our formula…
50 / (200 * 10) = 0.025 lots
So what does it mean?
It means that for a risk of $50 per trade and a stop loss of 200 pips, you should trade 0.025 lots.
How to Set the Profit Target
Many traders find it a puzzle to set the profit target.
The good news is that there are many ways of doing it.
But your goal should be to place the profit target at a level where there are chances of the market reversing from, meaning that you expect opposing pressure to come in.
Let us discuss the three areas where you can set your profit target…
#1: Support and Resistance
These two can be defined as follows…
Support- The area where potential buying pressure can come in.
Resistance- The area where potential selling pressure can come in.
If you are in a long position, you can take profits at Resistance
If you are in a short position, you can take profits at Support.
This technique becomes useful when the market is in a weak trend or in a Range.
Consider the example given below…
The above chart shows a position at which you can take profits.
The black line running horizontally is the resistance.
The price action has been showing a slow upward trend to the point where it touches the resistance.
That is a good point for you to take profits.
Note that it’s not good for you to aim for the absolute highs/lows for your target since the market may fail to reach those levels, and then reverse.
This means that you must be conservative when it comes to your target profits and ensure that you exit some pips earlier!
#2: Fibonacci Extension
With a Fibonacci extension, you can project the extension of the current swing at the 127, 132 and 162 extension.
The technique is useful for a healthy or weak trend in which the price tends to trade beyond the previous swing high before retracing lower in an uptrend.
So, will it not be beneficial for you to predict how high the price will go and exit the trade before the price retraces?
That is why you need the Fibonacci extension.
Here the steps for you to follow when using it…
- First, identify a trending market.
- Draw the Fibonacci extension tool from the swing high to the swing low.
- Set the profit targets at the 127, 132 or 162 extension. This will be determined by your aggressiveness or conservativeness.
Do the vice versa for an uptrend.
Consider the example given below…
In the above chart, we are dealing with a downtrend.
You simply have to click the swing high, drag the cursor to the swing low and click there.
Next, drag the cursor to the swing high and click there again.
You’ll be done and the values will become visible on the chart.
#3: Chart Pattern Completion
This is a classical charting principle in which the market tends to find exhaustion once the chart pattern completes.
So, when do we say that a chart pattern is complete?
If the price moves an equal distance from the chart pattern, it is said to be complete.
Consider the following example…
The above graphic is an example of a complete chart pattern.
It shows equal distances from the highs to lows.
The price can be considered to be complete.
The market also seems to find exhaustion after the completion of the chart pattern.
The two bidirectional arrows are of the same distance.
Analyzing the risk:reward ratio professionally
At this point, you know how to set your stop loss and profit target properly.
It is now easy to calculate your potential risk:reward ratio!
Just follow these 3 simple steps…
target profit / stop loss distance
An example will make it easy for you…
Here it is:
Let’s say your stop loss is 50 pips and target profit is 100 pips.
The above formula can be applied as follows…
100/50 = 2
So, your potential risk:reward ratio is 1:2.
Which means that you risk $1 to make $2.
Conclusion:
Here is what you’ve learned…
-To make money consistently on Forex, always see your trades in terms of risk:reward ratio.
-The risk:reward ratio defines the prospective reward a trader can earn for each dollar they risk in an investment.
-To make the risk:reward ratio a powerful tool, combine it with other trading metrics.
-An example of such a metric is the winrate.
-When trading, the most important metric is neither your risk:reward ratio nor your winrate. It’s your expectancy.
-If you’re in a long position, take your profits at the resistance zone.
-If you’re in a short position, take your profits at the support zone.