In the forex market, risk management is vital to any trader’s success. No matter what type of trader you are, it’s imperative that you earn more money than you lose.
One way that this may be accomplished is by focusing on trade setups that have positive expectations. By doing so, will be able to build trading strategies that incorporate risk-reward ratios designed to sustain profitability over the long haul.
Understanding the concept of positive expectancy is an integral part of approaching the financial markets from a position of strength. Within the realm of psychology, positive expectations are a foundational aspect of the Pygmalion Effect.
Back in 1968, scholastic researchers, Rosenthal and Jacobsen observed that when higher expectations were placed on students, these students returned greater results. Rosenthal and Jacobsen established the correlation and named their findings after the ancient Greek king Pygmalion.
So, what does ancient Greece have to do with the financial markets and forex trading? On the surface, not much. But, Rosenthal and Jacobsen’s work may be readily applied to any trading strategy in the world’s currency markets. In acknowledging that taking a particular trade gives you a better chance of long-run profit than loss, you have confirmed a positive expectation. Thus, your given trading strategy has a defined purpose: to make money!
To be clear, having positive expectations has nothing to do with your win rate; it has everything to do with ensuring that your winning trades will produce greater returns than your losing trades! This may be accomplished in a variety of ways, one of which is by implementing a risk/reward ratio designed for success.
When it comes to building a trading strategy with a positive expectancy, forex traders rely on the risk-reward ratio. A risk-reward ratio is the comparison of a trade’s potential liability and payoff. It is calculated by dividing the amount of money being put in harm’s way by the anticipated profit. This is done in the live market by first identifying the trade entry point, stop loss, and profit target.
In simpler terms, the risk reward ratio measures your possible reward for every $$$ you risk. Let’s talk examples. For instance, say you have a risk reward ratio of 1:5. This entails the following:
What does this mean? It means that in order to avoid losing money, your win rate must be above 20% (ignoring commissions and fees). Also, it tells us that your profit targets must be hit at least 20% to break even, with the rest being losing trades. If your win rate is under 20%, then you are guaranteed to lose money over the long run.
Or, say you have a risk-reward ratio of 1:10. Now, you’re risking $1 to potentially make $10 and your breakeven win rate shrinks to 10%. In all honesty, a 1:10 risk-reward ratio is a bit outlandish for most forex traders; it is more applicable to a trade relative to penny stocks.
In any case, here’s how a 1:10 risk-reward ratio would play out for Erin the euro trader and the EUR/USD currency pair. The following example illustrates how Erin could start trading the EUR/USD with a 1:10 risk reward:
As you can see, Erin’s chance at success is modest given the tight stop loss and 1:10 reward ratio. Nonetheless, it only takes a few winning trades for Erin to be profitable; if one in ten trades is a winner, Erin breaks even.
So, what is the risk/reward ratio forex participants rely on? More on that in a minute.
What’s the recommended risk-reward ratio in Forex? The answer largely depends on your capital resources, aversion to losing money, and your trading strategy. For instance, if you’re a conservative fan of financial market day trading strategies, then your risk to reward ratio is going to be smaller than those of crypto swing traders.
Why? To break down this concept, let’s review the basic tenets of the risk/reward ratio as it pertains to risk management:
Essentially, your best risk-reward ratio is one that contributes to a long-run, positive expectation trading strategy. If you are an average forex retail trader, then a smaller risk-reward ratio of 1:2, 1:3, or 1:4 is more appropriate than a “homerun” 1:10 risk to reward.
The reason for this is that various risk/reward ratios have different probabilities of success. Accordingly, the chances of executing a winning trade with a 1:10 risk/reward ratio are much smaller than standard 1:2 and 1:3 risk-reward ratios.
Ultimately, your ideal risk to reward ratio gives you the best chance of reaching your trading and investment objectives. It depends on how much money you have, your expected return and your acceptable loss. Remember, good risk management relies on positive expectation risk to reward ratios!
To calculate the risk to reward ratio, you’ll first have to derive each of them separately. As a general rule of thumb, it is wise to first address your assumed risk before turning to your prospective reward. This is done by subtracting your market entry from your stop-loss order. When you’re done with risk, then calculate the reward by subtracting the take profit order from market entry.
The formula goes like this:
It’s important to remember that the risk-reward ratio is dynamic and changes with each trade setup. However, in broad terms, if the risk to reward ratio is more than 1, the potential risk is bigger than the potential reward. Conversely, if the ratio is less than 1, the potential profit is bigger than the potential loss. Take a look at an example below to see the different risk-reward ratios on a Forex chart.
Many experts and Forex traders believe that if you want to increase your chances of being profitable, you want to trade with the potential to make 3 times more than what you are risking.
This theory suggests that trading with a 3:1 reward-to-risk ratio is the right way to go about trading Forex!
Let’s see what this would look like in practice by looking at the table below.
You can clearly see that even if you only win half of your trades, you will still end up profitable at the end. In fact, with the 1:3 risk ratio, you’ll bag yourself $10,000. Not too bad, right?
Of course, you might be wondering why forex market participants wouldn’t just go with higher reward-to-risk ratios and start trading. The reasons for this vary but include transaction costs, price action, and exchange rate volatility. Nonetheless, it’s simply because it’s more difficult for price to reach a higher profit target than it is to hit the stop loss level.
At the end of the day, your forex trades need breathing room to cope with all the exchange rate fluctuations. Our advice? Don’t risk too much money trying to make big profits fast! Join the ranks of profitable traders by making sure that your risk/reward ratio matches your resources.
The risk-reward dynamic is a key aspect of successful forex trading. Accordingly, you need to ensure that your risk-reward ratio is in line for each and every trade you take. This may be accomplished by making sure that your resources complement your risk to reward aspirations. If they don’t, it will be difficult to sustain profitability over the long haul.
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