It’s true:
Risk Management plays a significant part in your trading success.
Yet, there is one metric most people gloss over.
In today’s article, you’ll discover what the risk reward ratio is, and how to include it in your trading.
Check it out:
What is the risk reward ratio?
This is a metric to see how much risk you are taking for each trade. Risk reward ratio is measured as the potential profit divided by the potential loss on your trades.
You want to find a balance that minimizes your risk while maximizing your trading opportunities.
How to use risk reward ratio in your trading?
– Risk Reward Ratio should be the first thing you calculate before taking any trade.
– Calculate it every time, even if you are sure of your prediction. It’s easy to lose sight of how much profit or loss a certain trade will make and get carried away with greed.
– Risk Reward Ratio is one of the best ways to create a plan for success. You should have your risk reward ratio set before you start trading so that it doesn’t get too high or low over time.
What is the risk reward ratio formula?
The formula for Risk-Reward Ratio is simple.
Just flip the wording from Risk/Reward to Reward/Risk.
This will give you a ratio that will identify how much you are risking in order to obtain a profit.
What is Risk?
Risk measures how much market value will be lost on a trade.
This is generally the distance of your stop-loss.
For example, if your stop-loss is 50 pips, your risk is 50 pips.
What is Reward?
Reward measures how much profit will be made on a trade.
This will be set by your take profit order.
For example, if your take profit is 100 pips, your looking for 200 pips profit.
So the ratio will give you a format like so:
1:2.
1:2 means you are risking 1 pip to achieve 2 pips.
How do you calculate risk reward ratio?
To work out the risk reward ratio is super simple.
All you have to do is follow this simple approach:
- Take the phrase Risk/Reward
- Flip it to Reward/Risk
- Input your pips
- Answer the equation
- Add “1:” before the answer.
- Produce the ratio.
Or in other words:
Reward / Risk = Risk Reward Ratio.
So if you are looking for 250 pips reward and a 20 pip risk, you get 1:12.5
Ok, so let’s move on with the example above:
If you were to risk 10 pips to achieve 100 pips profit, what would that give you?
- Risk / Reward
- (Flip) Reward / Risk
- Input: 100 pips / 10 pips
- Answer: 10
- Add 1: – 1:10
- Risk Reward ratio of 1:10.
Get it?
What is a good risk reward ratio?
The Risk Reward Ratio is an important concept to be aware of when it comes to forex trading. A lot of beginners in the field will think that a high risk means higher returns, but this isn’t always true.
Generally, a Risk-Reward Ratio of around 1:2 is considered average when it comes to forex trading.
But don’t get locked on to this figure.
Because you can have a risk reward of 1:2 and still not be profitable.
What is a bad risk reward ratio?
Risk Reward ratio over 1:0.25 means you are risking more than what you have gained in profit so far on this trade.
It means you are at risk of 1 pip for 0.25 pips.
These tend to be targeted at scalpers, but they are more likely prepared for this.
So if the ratio was 1:0.25, it would mean for every $100 you risk, you’re looking to earn $25.
A better way?
At the end of the day, it’s NOT the risk reward ratio that makes you the money, it’s your actual trading…
Instead, what you should do is not limit your profit potential.
This can be achieved in a couple of ways.
Firstly, the most basic is through a trailing stop loss.
Have you ever taken a profit at your pre-defined take profit level only to see it continue further and further, then think:
“Damn, wish I was still in that trade.”
If so, then a trailing stop loss could help you out.
A trailing stop loss means that instead of a fixed stop-loss, it will follow the price action up.
This is a great tool for these key reasons:
- You can stay in your trade for as long as possible until the market “kicks” you out by trailing the price.
- You never miss out on opportunity costs for taking an early profit.
- You don’t know if you are taking profit at the best opportunity, or the worst (if it continues to rise).
- You could have entered at the lowest point in the market and got out too early, thus missing out on the rest of the trend.
But trailing stop losses are not for everyone, some traders find the pressure of staying in a trade above their take profit too much to handle, or they want to move the margin into another potential trade.
Secondly:
This is what I believe is the most important money management tool available.
You can use Kelly’s Criterion to improve your position sizes based on your trading performance.
This is based on the theory that by increasing your position size in proportion to the probability of success, the return on a winning trade will exceed the losses from trading too small, and also you will achieve better risk control than just betting one unit size per trade.
The result is that over time, your average win-to-loss ratio becomes greater than 2:1 naturally.
It’s how the big boys trade, and you can use it too.
Read our full article on Kelly’s Criterion here.
But what you choose risk-wise is entirely up to you.
We’ve learned a lot about risk reward ratios and how to calculate them.
We should all be looking for the best possible ratio that works for us, but what is considered “best”?
The answer may not always be clear-cut, so we wanted to share some interesting insights into different opinions on this topic.
What do you think your ideal risk/reward ratio would look like? Let us know by reaching out to us via social media!
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