Risk/Reward Ratio

Frustrated with losses?

Continuously looking to alter your method?

If so, the following article may help.

What is risk/reward?

  • Risk is the amount of capital that one could potentially lose.
  • Reward is the profit that one could potentially gain.

Risk/reward is expressed as a ratio, and refers to the amount of profit we expect to gain on a position, relative to what we’re risking in the event of a loss. Knowing this helps traders manage risk.

As an example, a long trade on the GBP/USD that requires a 50-pip stop, and has a take-profit target set at 100 pips, would be expressed as 1:2 risk/reward ratio. If the take-profit target was 200 pips, however, it’d be expressed as a 1:4 risk/reward ratio.

In the real world of trading, risk/reward ratios are NOT set in stone. Each trader will be different depending on the trading environment, timeframe selection and entry/exit points.

To help hammer home this concept, let’s look at a couple of examples:

A scalper, someone who looks to make a large number of trades and earn a small profit each time, usually has to have a high win ratio (essentially means more winners than losers) and may aim for a 1:1 risk/reward on each trade (IF they’re lucky). Do this consistently and the scalping business can be extremely profitable.

Now, say our scalper executes ten trades per day and targets a 1:0.5 risk/reward ratio. In order to rinse a profit he/she would need to win at least seven out of ten trades. One thing to keep in mind, especially using this type of strategy, is that spreads and commissions can really eat into your bottom line if not correctly accounted for.

As a swing trader (someone who takes positions that can last anywhere from two days to two weeks), the win ratio may decrease. That’s perfectly fine when trading medium term, though, as risk/reward tends to be healthier than that of a scalper (when targeting a larger gain, the win rate normally decreases). Typically, we have found that swing traders bat for at least a 1:1.5 risk/reward ratio. Therefore, if the swing trader is able to win 50% of the time and register a 1:1.5 risk/reward ratio, a profit can be made.

The bottom line unfortunately is that a lot of traders lack the patience to consistently execute a large enough series of trades to realize the true power behind risk/reward. Traders often get disheartened after a loss or two. Placing so much emphasis on winning trades is irrelevant on its own.

Here’s why you may want to consider incorporating risk/reward ratios in your trading decisions:

  • Traders, especially those new to the industry, tend to focus on their win/loss ratio over their risk/reward ratio. Big mistake. A trader with a high win ratio and a shabby risk/reward ratio can end up in trouble.
  • A reasonably consistent risk/reward, over time, can help contain losses.
  • Measuring risk/reward can help locate high-probability trades. For example, say that you predominantly trade supply and demand areas, and you are about to enter long at a mouth-watering demand base. The demand alone is enough to get most supply/demand traders motivated. But what if the next supply is located nearby, measured at one times your risk i.e., a 1:1 risk/reward ratio from the entry point? Would you still take the trade? This, of course, will be dependent on what your desired risk/reward is per trade, as the supply will likely hinder upside. If one generally targets a 1:2 risk/reward, it may be best to pass on the setup. To calculate risk/reward, keep it simple. Assuming that your stop-loss distance is 50 pips and the underside of the opposing barrier is also 50 pips from entry, this would be considered a 1:1 risk/reward ratio.
  • Understand that you do not have to trade every day. Without going into too much detail, a long-term trader who only takes ten trades per year and has a risk/reward ratio of 1:3, but loses seven of those trades, will still make money at the end of the year. As long as risk/reward is in line, the win ratio and trade output over the year should not bethe front-line concern.

To summarize…

If you’re frustrated with losses, try directing your attention on the risk/reward element of trading. Even with three winning trades out of ten, as we’ve already highlighted above, one can still potentially make a profit! Let’s remember that losses are a part of trading. You could Consider it as an expense.

In addition to this, if you are one of those traders who continuously looks to alter his/her trading methodology after a few losses, and we know there are plenty of you who do this, stop what you’re doing. It could be helpful to trade the method on a demo account and log at least twenty trade examples. As you now know, you can effectively lose more than 50% of your trades and STILL make a profit. Give it a go. You’ll be surprised at how much you learn and develop without the need to chop and change your strategy, which could have been perfectly satisfactory to begin with.

Trade with discipline – set your risk; set your reward.

IC Markets
IC Marketshttp://www.icmarkets.com/
IC Markets is revolutionizing on-line forex trading; on-line traders are now able to gain access to pricing and liquidity previously only available to investment banks and high net worth individuals.

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