Risk/Reward Ratio – a tool in the money management system

There is a saying in the trading world that if you are trading without a stop loss and without having a proper risk/reward ratio you are doomed to failure. From my point of view this holds true only to a certain extent as it depends very much of the type of trader one is: scalper (meaning going for short term profits, taking quick bites out of the market and having as many entries as possible during the trading day) or a medium term investor (there are traders that do trade currencies based on the higher time frames charts, from the daily up to the monthly charts). So the statement above would most likely address the second category of traders mentioned here, as scalping can be very successful without having to employ stop loss and risk reward strategies.

On the other hand, a medium term investor is the one that resembles the professional trader, in the sense that his/her analyses are based on analyzing the market from both the technical and fundamental point of view. While the scalper will mainly look at fundamentals only to the extent of the moment of time the economic data/indicator is released, the investor looks to understand why a specific economic data came in the way it did, what it means for the currency, and how to trade that into his/her advantage.

Identifying a possible new trend does not mean the medium term investor will jump and take the trade just like that, but will look most likely for the setups that provide the most attractive risk/reward ratio.

A risk/reward ratio should be defined as the ratio between how much you are willing to risk for a specific outcome. For example, if a trader decides to go long eurusd at the 1.30 level and uses a stop loss of fifty pips, or 1.2950, and a take profit of 100 pips, or 1.31, the risk/reward ratio is 1:2, meaning for every pip risked, there are two pips of potential profit. The higher the ratio, the better, and traders strive to identify the proper setup to have this ratio as big as possible.

A good risk/reward ratio (also called rr ratio) is considered to be the 1:3 ratio, and there are traders who are effectively refusing to take some trades if the rr ratio they are basing their trading is not there and such rules are part of the money management system each and every trader should have.

The medium term investor will always look for those setup that provide the rr ratio they are looking for and because of that they already have a competitive advantage in front of scalpers as one successful trade with a 1:3 rr ratio should cover for three potential bad trades. And this is why the rr ratio should be incorporated in any money management system a trader uses.

However, there are some negative points related to trading with a specific rr ratio as markets spend most of the time in consolidation and having a big rr ratio implies one should trade only when markets are trending/moving. This depends very much on the risk taking, as the same rr ratio can be traded even when markets are not moving that much, so taking a lower risk will definitely be a way to go. But currency markets are characterized by extreme volatility levels and frequent spikes and that makes it difficult, if not virtual impossible, to find entry levels that assure a nice rr ratio starting with the smallest risk possible.

All in all, trading with rr ratio helps traders be more disciplined and trading is one area where discipline is needed if one wants to be successful.

Source: this article is a contribution by John from Forex Brokers Hub, the site which features detailed reviews of the most popular Fx brokers.