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Module 7: Lesson 2

  1. The Risk/Reward Ratio

The risk to reward ratio is a term that describes the mathematical relationship between risk and reward that you are willing to take on each trade as a trader.

Consider the following scenario:

We traded EUR/USD and, based on technical analysis, we have decided to buy a standard lot size with a profit target of 20 pips at the current price.

As a result, we make the following trading decision: 1 lot ($10 per lot) multiplied by 10 pips equals $100.

In other words, we want to make $100 for a 10 pip increase in the EUR/USD price. We also put our stop loss 10 pips in the opposite direction, risking $100, because we know a little about risk management.

In this case, our risk is ($100), and our reward is ($100), so our risk-to-reward ratio is 100:100 =1:1.

“Good traders are more worried or concerned with how much they are RISING than with how much money they might make. “

With a risk-to-reward ratio of 1:1, a trader will need a win rate of more than 50% to be successful over time.

As a trader, you can have any risk-to-reward ratio you want; in fact, you could have a risk-to-reward ratio of 3:1 or even higher.

Note: Maintain a risk-to-reward ratio of greater than 1:1.

What matters is that you comprehend what that means. Let us take a look at an example once more. How would you account for different risk and reward ratios 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?

On paper, a higher risk to reward ratio is clearly better, But why aren’t maximum risk-to-reward ratios used by everyone?

The market makers are well aware that anyone serious about trading is mindful of the principle that they can increase their account capital even if their win-loss ratio is less than 50%.

Also, keep in mind that the further a level is from the current price, the more difficult it is to hit that level before the closest ones.

As a result, a higher risk-to-reward ratio will only work if you can keep the win-loss ratio constant (which, in reality, it may not be as easy as it seems).

Trading a percentage of your account per trade is another way to reduce your risk per trade.

Many forex traders recommend risking no more than 2% of your total trading capital per trade. This means that if you have a $1,000 account, you can only lose $20 if you make a complete flop of your trade. Learn why risk management is crucial.

The advantage of risking only a small percentage of your trading capital per trade is that you can trade multiple times at once. (This spreads and separates your risk.)

You can easily calculate your risk using this calculator.