Sponsors

The Importance of the Risk: Reward Ratio

Forex Trading | by Dailyfx.com | Friday, 13 November 2009 01:30 UTC
Trader A has a win percentage of 75% on all trades while trader B has a win percentage of closer to 40% on all trades. Which trader is more profitable?
 
Of course we can’t answer that as we don’t know how much each trader makes when they are right compared to how much they lose when they are wrong. So the win percentage is not the most important factor in trading. I’m sure that we would all like to win most of our trades, but if our goal is to be profitable, then there is more to the equation. It is called the risk:reward ratio and is one of the most important aspects of money management and a key to becoming a consistently profitable trader. Let’s take a look at some examples:

If you risk 100 pips and look for 300 pips in profit, your risk:reward ratio is 1:3 meaning one pip of risk for every three pips in potential profit.

If you risk 100 pips and look for 200 pips in profit, your risk:reward ratio is 1:2 meaning one pip of risk for every two pips in potential profit.

If you risk 100 pips and look for 100 pips in profit, your risk:reward ratio is 1:1 meaning one pip of risk for every one pip in potential profit.

If you risk 100 pips and look for 50 pips in profit, your risk:reward ratio is 2:1 meaning two pips of risk for every one pip in potential profit.

If you risk 100 pips and look for 25 pips in profit, your risk:reward ratio is 4:1 meaning four pips of risk for every one pip in potential profit.

So trader A would not be profitable using a 4:1 risk:reward ratio while maintaining a win percentage of 75%. On the other hand, trader B using a 1:2 risk:reward ratio while maintaining a win percentage of 40% is a profitable trader. I would recommend that new traders use a 1:2 risk:reward ratio in their trading. If you open a trade with a risk of 25 pips, then try to get twice that or 50 pips in profit. I would also recommend moving your protective stop up to breakeven when the market moves halfway to your target. An example of this would be if you bought at 1.2500 and placed your protective stop at 1.2475, your risk is 25 pips. Using a 1:2 risk:reward ratio means placing your limit order to take profits at 1.2550 for a potential gain of 50 pips. When the market moves up halfway to your target which would be the 1.2525 level, you move your protective stop from 1.2475 up to your entry level of 1.2500. At this point, you can only win or break even on the trade. Then you can spend your time looking for the next trading opportunity instead of following the current trade.

Written by Dailyfx.com

dailyfx

Recommended Forex Trading Platforms

Forex Trading We know that the right opportunity can happen at anytime, anywhere. Saxo Capital Markets is committed to giving you a suite of platforms that will enable you to access your account and trade the markets whenever and wherever you want.

Sponsors

Subscribe to Newsletter

To receive alerts by email when Free Forex Analysis are updated. Enter your email address below.