Assessing Risk and Reward in Forex Trading

Forex Trading | by ForexCycle.com | Friday, 27 February 2009 03:50 UTC

The question of measuring risk and reward in the forex market is a very complex one. It is very difficult to find the correct response due to the inconstancy of market conditions. In this sense, risk and reward in forex trading is similar to the weather, which means that there are no laws, only approximations.

The most common advice concerning risk and reward tells us to apply a ratio not less than 2:1. This means that we should look at the number of pips we are attempting to get and divide it by two. The result is the amount we will risk. Namely, assuming that we are looking for a profit of 200, our stop will be 100.

At first, this seems to work like a charm, given that we must only be right four times out of ten in order to gain profit. Yet, it is very hard to find somebody who has really applied this successfully in the long term. And while theoreticians, who have never risked anything or had their main income depend on forex trading, will be quick to suggest this method, it is virtually impossible to find someone that uses this two to one method to guarantee their main source of income.

This can be chiefly explained by the fact that those that do not earn a living by trading cannot see that the forex market grants no rewards, it solely implies risk. Markets are highly mutable and seldom do they fulfill your hopes and expectations. Let us say that we wager 50 points and our goal is to obtain 100. In the beginning, the floating profit and loss will increase up to +99 and everything would be fine. Now, we pursue this method and stand by for our goal to be achieved in order to take on one more profitable deal. However, the market unexpectedly halts and goes backwards. A highly profitable trade then just reverses and plunges through our stop. While it seems that we suffer the loss of only 50 points, in reality we are deprived of 149 points, since we have lost our 50 and the 99 we failed to secure. This is, unfortunately, how the harsh reality of forex trading works.

What it boils down to is the fact that we can never predict rewards in forex trading. Rather, the best we can hope for is to regulate risk.

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