Hey traders,
Planning your every Forex trade, you should know in advance the profit that you are aiming to make and the maximum amount of money you are willing to lose.
In this educational article, we will discuss risk reward ratio - the tool that is used to compare your potentials losses and profits in Forex trading.
What is Reward to Risk Ratio
Let's start with an example. Imagine you see a good buying opportunity on EURUSD. You quickly identify a safe entry point, your take profit level and stop loss.
From that trade you are aiming to make 100 pips with a maximum allowable loss of 50 pips.
To calculate a reward to risk ratio for this trade, you simply should divide a potential gain by a potential loss:
R/R ratio = 100 / 50 = 2
In that particular example, reward to risk ratio equals 2 meaning that potential gain outperform a potential loss by 2.
Let's take another example.
This time, you decide to short USDJPY.
From a desirable entry point, you can get 75 pips rerward with a potential loss of 150 pips.
R/R ratio = 75 / 150 = 0.5
Reward to risk ratio for this trade is 75 divided by 150 or 0.5.
Such a ratio means that potential loss outperform a potential gain by 2.
Positive and Negative Reward to Risk Ratio
Risk to reward ratio can be positive or negative.
If the ratio is bigger than 1 it is considered to be positive meaning that a potential gain outperforms a potential loss.
R/R ratio > 1
If the ratio is less than 1, it is called negative so that potential loss is bigger than potential risk.
R/R ratio < 1
On the left chart above, the reward for the trade is bigger than a risk.
Such a trade has positive reward to risk ratio.
On the right chart, the risk is bigger than a reward.
This trade has negative reward to risk ratio.
Why?
Knowing the average risk to reward ratio for your trades, you can objectively calculate the required win rate for keeping a positive trading performance.
With R/R ratio = 0.5
2 winning trades recover 1 losing trade.
You need at least 70% win rate to cover losses of your trading.
With R/R ratio = 1
1 winning trade, recover 1 losing trade.
You require at least 50% win rate to compensate your losses.
With R/R ratio = 2
1 winning trade recovers 2 losing trades.
You will need at least 35% win rate to cover losses of your trading.
In the example above, the trading setups have 0.5 reward to risk ratio. In such a case, 2 winning trades will be needed to win the money back for 1 losing trade.
Forex trading involves extremely high risk. Risk to reward ratio is a number one risk management tool for limiting your risks. Calculating that and knowing your win rate, you can objectively decide whether a trade that you are planning to take is worth taking.
