Risk to reward ratio and how can it influence your trading?

Trading financial instruments is increasingly becoming more and more popular. Brokers are offering more and more assets to trade to their clients, opening trading accounts is much easier than it’s ever been before. Trading related information is widely available around the world on the internet. There are lots of webinars, seminars and guides to help you boost your knowledge. From this standpoint trading might seem easy. However, the sad reality is that most traders blow up their accounts and fail at trading consistently profitably.

The main reason why most traders lose is that they fail to manage their risks. One of the most important aspects of risk management is understanding the risk and reward ratio. In this guide we’ll dive deep to fully understand the relationship between the two and help you choose the best ratios for your trading.

Understanding risk and reward relationship

When you open an order and place a Stop Loss, the amount you will lose if the price hits that target is called your risk. The amount you will gain if the price hits a Take Profit target is referred to as reward. The relationship between the two is called risk and reward ratio. For example, if you lose 100 USD when a price hits your stop loss and gain 500 USD if a price activates take profit order, the risk to reward ratio is 1:5. When your risk-reward ratio is 1:5, the more you risk the more the rewards can be. In this instance, if we risk 200 USD instead of 100 USD, the potential reward will be one thousand USD.

Choosing an optimal risk and reward ratio

Choosing an optimal risk and reward ratio gets complicated when we add another dimension to the mix, called probability of outcome. Generally traders pick 1:1 or higher risk to reward ratios to keep trading simple.

If the likelihood of price going in the predicted direction is 50%, it doesn’t make any sense to use 1:1 risk and reward ratio. As at the end of the day you won’t have a trading edge and will likely lose money due to the trading related fees. In this case, traders need 1 to more than 1 ratio to make it work.

When the likelihood of pattern compilation in the predicted direction is higher than 50%, it is possible to choose a 1:1 risk and reward ratio. Thanks to that 2 dimensional nature, it’s hard to name the optimal numbers for risk and reward. The numbers can be various depending on the situation and trading setup.

One thing that’s the most important when choosing the ratio is to ask yourself whether it gives you a trading edge or not. Trading edge doesn’t guarantee that your next trade will be in profits, however, it guarantees that over the long run, the more you trade, the more profits you will gather.

Profitable trading with an edge is like going to a casino but reversed. Any mathematician will tell you that the best probability of winning in a casino is to bet once, win or lose and go home. The more you gamble, the more you will lose. Professional traders never put everything on a single trade. They use an edge to increase their balance in the long run. Understanding the risk and reward ratio is an important aspect of learning how the trading edge works.

Risk and reward ratio and risk management

There are various reasons why most traders fail to manage their risks properly. Most obvious one is that they lack the understanding of trading edge, risk and reward ratios and the importance of risking a small percentage of their balance in any given trade.

Risk and rewards are positively correlated. In other words, if you increase the position size, your risks will increase, as well as your potential rewards.

However, as we have already mentioned, you should never overextend yourself in any single trade. Probabilities do not work in single digits, they work for large numbers. The more trades you place using an optimal risk and reward ratio, more steadily your account will grow.

Risk and reward ratio in Forex and in other markets

Forex market is more cyclical than the stock market. From the initial public offerings, certain stock prices can go from 0 to potentially infinity. As a result stock markets are more in trend. Forex currency pairs are always in relation with one another. For example in GBP/USD pairs the British Pound is measured in relation to the US Dollar. Consequently prices are more in a range. Forex trading strategies usually offer 1:1, 1:2, 1:3 to 1:5 risk and reward ratios. Whereas, on some occasions you can find 1:10 risk and reward ratios in the Stock market. Stock prices tend to respect significant levels more. And significant levels are producing the best risk and reward rations as your stop losses can be placed a couple of pips away from these levels.

Dynamic risk and reward ratio

It’s important to note that predetermining risks and reward targets definitely helps planning a trade. However, in live trading, not everything can go according to plans. For instance, let’s say you have placed an order along with the stop loss and take profit limits. The price goes towards the take profit target and the volume and other indicators are hinting to you that the price will exceed your target. In such occasions it’s logical to remove the take profit target. And many traders actually do so. Some partially close their positions and remain in the trade as long as indicators give promising signs. Others use trailing stops to milk the price move.

In some occasions traders move the stop loss targets as well. Let’s take a look at this scenario: you have placed an order and the price does go in your preferred direction sharply. And you move the stop loss higher, so that even if the price reverces, you close the trade above negative balance. This might make sense from the start but it happens quite often that the price reverseas, takes traders out of the game and rallies back towards the previous take profit target. Stop loss and take profit targets are chosen for a reason, usually their placement is determined by significant levels, indicators and other factors. When changing the target, it’s important to have a good reason behind it.

Furthermore, some patterns can give you stop loss targets and help you calculate your risks, but totally fail to give you an idea about rewards. For instance, trading patterns that help you join trends, usually are great at giving you ideas on where to place stop losses, however, rewards depend on the strength of the trend. Generally patterns are offering good risk and reward ratios, even when the rewards are not clearly defined.

Many traders blow up their accounts because they cannot take losses. As already mentioned, losing is a part of the game. Once in trade, you should never increase your risks by moving stop loss orders away from the market price. Let’s say a trader has purchased EUR/USD and price drops near the stop loss. The trader moves stop loss lower hoping the price will reverse, and witnesses another price drop, this can go on till the account balance is dried up. In this case, it would have been better just to take the loss and focus on other trading opportunities. Once in trade, the risk and reward ratio can only be changed if you have good reason and only in favor of enlarging rewards while minimizing the risks.

Accepting the losses is one of the biggest challenges beginners face. Discipline and controlling human emotions is the key. In order to be less emotionally dependent on the losses, it’s a good idea to have a side job or a business. It’s really difficult to lose money trading when your bills need to be paid. If you are planning to trade professionally, you need to accept the realities of trading.

How to make trading decisions based on risks and rewards?

Sometimes, even when you have a good risk and reward ratio, it is hard to make a trade. The reason behind this is that there’s another dimension to take into account such as the likelihood of moving the price in the preferred direction. Every trade needs to be planned individually. It may sound paradoxical, but the main goal of a trader should not be to make money or to win a trade. The main goal should be to trade flawlessly and the money will follow. Traders should look for opportunities that give them statistical advantage that comes into play the more they trade. Risks should never be too high. If one or even 10 losing trades in a row can get you out of the game, then you’re doing something wrong. In trading, as in life, there are good days and bad days. And sometimes these bad and good days group together and the bad day is followed by another one and another one. The key to success is surviving the bad days and milking the good ones. Many traders even take a short break from trading when nothing seems to work. They switch to demo trading, gain back their confidence and start trading again.

The main takeaways

To sum everything up, the most important reason why the vast majority of traders lose money and blow up their accounts is because they fail to manage their risks. Understanding how risk and reward works in trading can help you manage your risks better. Calculating risks and rewards as well as choosing the trading position sizes are the key when it comes to risk management.

If your trading strategy has a 50% outcome probability, your risk and reward ratio should be 1:higher than 1 in order to result in account growth over the period of time. If your strategy has a higher than 50% outcome probability, even a 1:1 ratio can bring you profits. The higher, the better, however, finding such setups is not easy.

Keep in mind that risks and rewards can be changed when managing your trades, however, you should always have good reasons to move the targets if you decide to do so.

FAQs on the risk and reward ratio in Forex trading

How does the risk/reward ratio work?

Understanding risk/reward ratio is essential in Forex trading. The ratio simply shows the relationship between your risks per trade and potential rewards. For example, 1 to 3 ratio means that when you are placing an order and place 10 USD Stop Loss, price hitting the Take Profit target will earn you 30 USD.

What is a good risk reward ratio?

It depends on the trading setup. There are trades that have good risk and reward ratios, however, the probability of a positive outcome might not be great. When considering risk and reward ratios, it’s important to think about how likely it is for the setup to predict the price. Generally traders choose 1:1 risk and reward ratios and higher.

How do you calculate risk reward ratio?

In order to calculate the risk and reward ratio, measure how much your Stop Loss will cost you if the trade goes against predicted price, measure how much your returns will be if the price hits the Take Profit target and compare with one another. For instance, if the risk is 10 USD and the potential reward is 50 USD, the risk and reward ratio is 1:5.

Can risk to reward ratio change once in trade?

Yes. Predetermining the risks and rewards helps us plan our trades better. But on some occasions markets can change our plans. Something unexpected can always happen. Furthermore, technical indicators might signal you to stay in the position longer, which can magnify your rewards. However, moving your stop loss and increasing your risks is a bad idea. Most traders blow up their accounts because they can’t take losses. You can run your profits but you should never let your losses get too big.