The FX market primarily involves traders taking risks to gain rewards. If you are a novice in FX, there is a high chance that you do not know how to calculate risk accurately and what role the risk-reward ratio plays. For the uninitiated, the risk-reward ratio is used to quantify how much you are willing to risk to make a profit from a particular trade.
What is risk-reward ratio in trading FX?
The risk-reward ratio is a measure of potential profit per trade, relative to potential loss. In FX trading, if you buy EUR/USD at say 1.2500 and place your stop-loss order at 1.2450 and your take profit to 1.2650, you are risking 50 pips for a potential profit of 150 pips. In this case, the risk-reward ratio is 150/50=3:1. Such a ratio statistically provides you with greater chances of being profitable in the long run.
How to calculate the risk-reward ratio in Forex?
The formula for finding out the risk to reward ratio is pretty easy. If you risk 100 pips and set a profit target of 150 pips, your risk to reward ratio will be ½ or 1:2. To effectively analyse risk and reward before every trade, always consider the spread being provided by your broker. Using an inaccurate risk to reward ratio will no doubt hamper your trading and even lead you to incur heavy losses.
Let’s say, you are a scalper and like to gain around 10 pips from each of your trades by risking a maximum of 5 pips per trade. If you are thinking that the risk-reward ratio is 1:2, you are wrong. If the broker charges 2 pips for spread on a USD/CAD, you are actually risking 7 pips (5+2) while expecting a profit of 8 pips. Thus, in this case, your net risk-reward ratio is 1:1.14 instead of 1:2. This is a very common mistake traders make as they fail to consider the transaction costs associated with the trade while calculating risk/reward.
Now the above ratio of 1:1.14 isn't favourable as you would require a much higher win rate to cancel out the large risk to reward ratio due to the difference in spreads. Let’s look at another example involving the GBP/JPY. Suppose you are trading the pair and your broker charges a spread of 5 pips. If you set narrow profit targets and stop losses while scalping, your risk to reward ratio will be distorted because of such a high spread. So the risk-reward ratio for risking 100 pips for a 200 pip profit, in this case, would be:
Risk = 100+5=105 pips
Reward = 200-5=195 pips
Risk/Reward Ratio: 1:1.85
So in this case, because of the higher time frame being used, the spreads have minimum effect on your risk-reward, as it will just change from 1:2 to 1:1.185. Thus, spreads will negatively affect scalpers or short –term traders in comparison to swing or position traders.
Risk/Reward Ratio and Risk Management in Forex
Novice traders make a common mistake of making consistent profits, only to have them wiped out by one, ill-informed trade. This is exactly why forex risk management is needed in these situations. Your aim should be to gain your desired profit by balancing it with the right amount of risk per trade. To make this balance realistic, you have to select an appropriate risk /reward ratio.
It may so happen that you decide to set a profit target which is 3x your initial stop loss. Here the risk to reward ratio is 1:3. But if your strategy isn’t suited to deliver this ratio in the long run, you can eventually incur heavy losses. On the other hand, if you leave trading after profiting only double your initial stop-loss when your strategy can handle a 1:5 ratio, you’re simply losing out on a lot of money. Experienced traders spend a lot of time back-testing their strategies till they find a realistic profit level that makes each trade relative to the trader’s stop loss. A 1:1 Risk Reward Ratio is not advised under any circumstances in fx trading.
Limitations of Risk/Reward Ratio
Simply using a low-risk reward ratio is not enough to trade profitably. A common mistake traders make is to have a preconceived ratio in their heads before they analyse a trade. This can lead you to base your profit targets and stop-loss on your entry point without considering market conditions. Thus, choosing the best risk-reward can be best described as a balancing act. You need to develop a trading plan which effectively provides you with stop loss, profit targets, and the points where and when you want to trade. It should also be under acceptable market conditions.
Expert traders use risk-reward ratios in conjunction with other risk management ratios such as the break-even percentage, and the win/loss ratio, the latter of which provides a comparison of winning and losing trades.
Some Tips to use Risk/Reward Ratio in your Forex Trades
- Never forget to calculate broker spread when calculating your own risk-reward ratio as it can mess up your profit calculations later on.
- Many popular trading books advocate the use of a pre-determined risk to reward ratio. But always try to use extensive data analysis to find out which ratio is better for you instead of using predetermined 1:2 or 1:3.
- Judge each trade based on their merit and open trade only when it meets all of your pre-set trading rules.
- It is mandatory that you assess the risk-reward ratio of a trade before you enter it.
- You cannot turn a bad trade into a good one with higher risk-reward ratios.
Traders often disregard the importance of trading expectancy and risk-reward ratio as they get consumed by their winning percentage. An active day trader may set a ratio of 1:2 while long-term swing traders might aim for something above 1:5. Regardless, it is something that you should determine after evaluating your personal trading objectives and goals.