Risk reward

We say it again - "forex trading carries risks" and it's up to you as a trader to manage it as well as protect yourself from the risk associated in each trade. Risk Reward Ratio is a great tool to assess the level of risk in each trade. The ratio is calculated by dividing the expected profit (reward) by the potential loss (risk).

Here are a few examples of the risk-reward ratio:

  • If the risk is $400 and the reward is $800, then the risk-reward ratio is 400:800 or 1:2
  • If the risk is $1,500 and the reward it $4,500, then the risk-reward ratio is 1500:4500 or 1:3
  • If the risk is $1,00 and the reward is $50, then the risk-reward ratio is 100:50or 2:1
What is a good Risk-Reward ratio?

The risk reward ratio is a function of your risk appetite. It varies from one person to another based on the time frame of investment, market conditions as well your entry/exit points. For new comers in the business you can work with a ratio of 1:3. Any number below 1:3 is too risky so the trade should be avoided. Never enter a trade in which the risk-reward ratio is 1:1 or the risk outweighs the reward.

Many experienced traders will only enter trades in which the risk-reward ratio is 1:5 or higher. This requires that the trader wait for a trade with this ratio, but the reward is worth it. A higher risk-reward ratio is a good idea in case the currency does not make the anticipated price movement. However, if the trader uses a lower risk-reward ratio, there is very little room for smaller price movements and the amount of risk will increase.

Levels of Drawdown – Discussion of risk to reward

Depending on your trading style – aggressive or conservative, you will take on higher risks for potentially higher rewards. Such traders are willing to take up to 50% or more in drawdown of capital, while a conservative trader will not dream of a drawdown of 20% or greater.

How is drawdown related to risk reward ratio? It should be understood that if one's trading is generating losses, instead of returns, and the account is approaching a trader's maximum drawdown level, it is an indication that your trading methods and tools are ineffective. Now you should stop trading, go back to the drawing board to re-evaluate your trading strategy.

You should know that small losses are part of the trading plan, as some positions will end as losers and others will be winners. However, it is important to have an average between the two that is positive. This means that the winners are bigger than the losers and an account is building equity.

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