Risk to Reward Ratio in Currency Trading
Many new traders think that a good entry into the markets is the key to success. Unfortunately, most are wrong. A risk to reward ratio compares the potential for reward with the potential for loss.
Risk is measured by counting the number of pips between the forecasted entry price and the forecasted price at which you want to exit the market in case of a losing trade. A trader must view each trade as a business transaction. Risk is just a measure of how much you can lose in a trade.
Reward is calculated by counting the number of pips between the forecasted entry price and the forecasted price at which you would want to exit the market in case of a winning trade. Reward is the expected number of pips that you want to make in a trade.
To manage risk properly, you need to look for high probability trades that have a risk to reward ratio of 1:2 or greater. This depends on the time frame that you want to trade. For example, if you are a day trader and you are looking for making only 30 pips in a trade, a stop loss of 15 pips is sufficient for the risk to reward ratio of 1:2.
However, if you are a swing trader or a position trader with a longer time frame, your profit potential will be more. If you choose 200 pips as your expected profit then you will need to set your stop loss at 100 pips.
Retracements on shorter time frame are much smaller. Retracement on the larger time frame is much bigger. The reason that you need to set a higher stop loss on a larger time frame is that small trends occur within the larger trend. In order to be not stopped out of the trade, you need to calculate your risk to reward ratio appropriately. Due to smaller trends in the larger trends, your trade is going to be recycled.
You must agree that next to maximizing profits, the second most important thing for you is minimizing losses. A trading system that wins 50% of the time can still be profitable. The unfortunate thing about most of the traders is that they want to make money but dont know how to protect what they currently have.
You have a 50/50 chance of the currency market going your way. It is just like flipping a coin. In case, the trade does not develop in your favor and the market is going against you, you should cut your losses by using stop losses. In simple terms, you cut your losses and let your winners run. This simple 50/50 trading strategy earns a profit even when a novice trader might experience a loss.
Consider the following different risk to reward ratios. For 2:1 risk to reward ratio, you will need 67% winners just to break even. For 1:1 risk to reward ratio, it means 50% winners to break even. 1:2 ratio means 33.5%. As I have said before, never ever trade when the risk to reward ratio is more than 1:2.