Hey traders,
Planning your every 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.
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 risk to reward 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, risk to reward 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 with a potential loss of 150 pips.
Risk to reward 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.
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.
If the ratio is less than 1, it is called negative so that potential loss is bigger than potential risk.
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 need at least 50% win rate to compensate your losses.
With R/R ratio = 2
1 winning trade recovers 2 losing trades.
You need at least 35% win rate to cover losses of your trading.
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.
