The risk to reward ratio is a term used to describe the mathematical relationship between risk and reward you as the trader are willing to take on each trade.
I trade EUR/USD and using technical analysis i determine that i want to buy with a standard lot size looking to profit 20 pips at the current price.
Hence i make this trading decision:
1 lot ($10 per lot) x 10 pips = $100.
In other words I’m aiming to gain $100 for a move up in the EUR/USD price of 10 pips. Also because i know a bit about risk management, I put my stop loss 10 pips in the opposite direction, hence risking $100.
In this case I have a risk of ($100) and a reward of ($100) therefore my risk and reward ratio is:
“Good Traders are more CONCERNED about how much they are RISKING than what they will POTENTIALLY MAKE.“
For a trader to be successful with a risk and reward ratio of 1:1 overtime that trader will need an above 50% win rate.
You as a trader can have any risk and reward ratio you please, in fact you could have a 3:1 risk and reward ratio, or even greater than that.
Key: Alway keep your risk to reward greater than 1:1.
The important thing to understand is what that means. Lets look an an example again.
If you traded 20 trades on EURUSD, aiming for 20 pips, and without accounting for spread and commission – you won 5 trades and lost 5 trades using a standard lot size, how would you account look for different risk and reward ratios:
It can be seen above that a higher risk to reward ratio on paper is definitely better.
But why doesn’t everybody use maximum risk to reward ratios?
The market drivers know that every person that is serious about trading understands this principle that they can increase their accounts capital even if they have a win loss percentage of less than 50%.
Also remember that the further away a level is from current price, the more difficult it is that level will be hit before the closest levels.
So a greater risk and reward ratio will only work if you can actually maintain the win loss percentage ( which in reality is not as easy as it seems. )
Another way you can streamline your risk per trade is to trade a percentage of your account per trade.
Many forex traders recommend that you risk a maximum of 2% of your entire trading capital per trade.
This means that with a $1000 dollar account, even if you made an absolute flop of your trade you would lose a maximum of $20. See why risk management is important.
The positive of risking only a little (2%) of your trading capital per trade means that you can take other trades at the same time. (This diversifies your risk.)
With this calculator you can easily calculate your risk.
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