Risk to reward ratio's when trading Forex markets, refer to the amount of financial gain expected, compared to the level of capital risked. A trader's level of risk to reward will form an integral part of their trading strategy and can be a very useful tool in managing capital and protecting risk.
In This Article
- What Is Risk When Trading
- How Does Risk To Reward Ratio Help Forex Traders
- Determining Whether A Trade Is Viable
- Limitations To A Risk Reward Ratio
- Summary
What Is Risk When Trading
Risk when trading refers to the amount of capital that can potentially be lost on any one trade. This is subjective and will be determined to a trader's appetite for risk and should be set out in a well written and considered trading strategy. Generally speaking, no more than 1%-5% of capital should be at risk at any one time.
By means of example, if an initial deposit is made into an online trading account of £10,000 and a trader's risk appetite is 5%, the total amount at risk should be no more than £500. If more than one trade is placed, the level of risk should split equally between the amount of trades i.e., £500 risk over five open trades would allow a level of risk per trade of £100.
Risk is controlled by placing a stop loss order when placing a trade. A stop loss order will automatically close a trade once a pre-determined price point has been reached, this allows a trader the security of knowing that if a position moves against them, their losses are limited to a manageable level.
How Does Risk To Reward Ratio Help Forex Traders
It is important to remember that no trader wins every trade! Incurring losses is an inevitability of trading and it is essential to treat a loss objectively and view it for what it is, a simple cost of trading.
A common problem for new traders is accepting losses and instead of understating that risk losses have to be managed, simply refuse to accept them at all. This can lead to emotional trading and holding onto to losing positions too long, allowing the losses to scale out of control. It is always better to accept a small manageable loss and trade another day, than to put your capital at an unacceptable level of risk.
A risk reward ratio is essentially a calculation that determines how many trades are required to break even. As previously stated, this will be bespoke to individual traders so do not try to compare yourself to anybody else, it needs to be set at a level at which you are comfortable.
A generally accepted level of risk reward is 1:2 i.e., for every £1 invested, £2 is expected in return. What this means is that only one in three trades needs to be successful to maintain breakeven.
By way of an example let us say that 3 trades are placed with a risk of £50 on each, two fail and one is successful. 2 x £50 losses = £100. 1 x £100 win = £100.
Of course, if a trader is more risk adverse, they may look for a greater ration 1:3 or 1:5.
Having a pre-determined risk reward ratio that is adhered allows a trader to accept losses. So long as the ratio is maintained, breakeven will be sustained as a minimum.
Determining Whether A Trade Is Viable
To assist with demonstrating how a trader should assess the viability of trade we will look at an example:
Looking at the above GBP/CHF 1h chart we have identified levels of support and resistance. Price has recently reached support and confirmation of has been identified following the close of the following candle. At this point a trader may be looking to place a long position in the expectation that price will again reach resistance. We have placed a stop loss level to just below previous "fake out" levels, if price moved beyond this, it may be a large breakout and we would want to close our position.
Above is a screenshot of the order where we can calculate whether the trade is viable i.e. does it meet our risk to reward ratio as set out in our trading strategy?
There are two entries, stop loss and take profit. Stop loss is set at 1.22000 which will incur a loss of £24.52, the take profit is set at the level previous resistance 1.22898 and return a profit of £48.87. The trade achieves a risk to reward of 1:2 and would be an acceptable trade to enter.
A problem that some traders struggle with is making the trade meet the criteria by adjusting the stop loss order to suit. The stop loss may be decreased to achieve the ratio, in reality this can be counterproductive as it increases the chance of the loss being realised.
Limitations Of A Risk Reward Ratio
Having a sensible risk reward ratio as part of a well written trading strategy is an extremely effective method of risk management, however, it is not a guarantee of success. Traders will still need to assess the potential trade using whatever form of technical or fundamental analysis they chose. Only when a potential trading opportunity has been identified and meets pre-defined trading criteria, should risk reward be brought into consideration.
Summary
A sensible risk reward ratio is an effective form of risk management, limiting exposure and protecting a traders overall capital investment. While a risk reward strategy cannot guarantee success, it protects trades from spiralling out of control by way of effective use of stop loss orders that should be placed at the time of entering a trading position.
Risk reward ratios are subjective and must reflect the risk appetite of the individual. Generally accepted levels of risk are 1% - 5% of trading capital with a risk reward of no less than 1:2.
