Are you having trouble deciding on how much to invest or trade in the foreign exchange (Forex) market?
How do you manage the risks to your portfolio if you are wrong?
This is where the risk-reward ratio could help!
In this article, we will detail to you what is the risk-reward ratio, how you can use it, and what is a good ratio to look out for.
What is the Risk Reward Ratio?
According to Investopedia, the risk-reward ratio is defined as the return an investor can expect to get for every dollar they risk on an investment.[HW1]
In simple terms, if you are risking $1 in losses, how much profit are you expecting from the trade?
A 1:1 risk-reward ratio means if you are risking $1 in losses, you expect to get $1 in profits.
A 1:5 risk-reward ratio indicates that for every $1 in losses, you expect $5 in profits.
Forex traders would normally set a stop loss target when they enter a trade. This is the highest amount that he or she is willing to lose. And that is about 2% of their total portfolio value.[HW2]
For example, if a trader has a total currency portfolio value of $100,000, he or she will set a stop-loss target of $2,000 (2%).
Based on the risk-reward ratio, a 1:1 and 1:5 ratio would mean that you expect to make $2,000 and $10,000 in profits respectively.
For a 1:1 ratio, your trades need to be right more than 50% of the time to make a profit. Equivalently, for a 1:5 ratio, that percentage only needs to be 20%. That one trade could cover the total losses from other trades.[HW3]
However, there is no free lunch in this world.
To make higher profits, you need to take more risks. You have a higher chance of taking $2,000 in profits compared to $10,000.
That’s why it’s important to determine your risk tolerance and preferences.
What is a Good Risk Reward Ratio for Forex Trading?
Investopedia suggests that an appropriate risk-reward ratio is about 1:3. That is fine for a starting point but ultimately it will depend on your risk preferences.[HW4]
A good risk-reward ratio fulfils your trading objective. Do you want one that is stable but doesn’t make much profit? Or one that is high-risk but which yields you a higher profit?
If you have a family to feed and loans to pay, you can’t take so many risks. You look for risk-reward ratios that are about 1:1 or 1:2 for any forex trades.
You will be making less profit. But they are more realistic as you don’t have to make as many trades in the market to obtain them.
However, if you want to take as many risks as possible, a risk-reward ratio that is above 1:3 will be suitable.
You will be making more trades in the forex market as the chances of higher profits are slimmer. Just one or two trades could make you profitable but it could take a long time.
Summary
Risk-reward ratios could help you determine how much profit you can expect from an amount that you are willing to lose. It also allows you to allocate an ideal position on your trades based on your total portfolio value.
In the end, your risk preferences will help you decide what kind of risk-reward ratio is suitable for you. Lower risk, lower risk-reward ratio and vice versa.
