Whether you’re a retail forex trader or professional, one of the few safety nets you have when it comes to preserving your capital is what’s called a risk/reward calculation.
Risk vs. Reward
It’s unfortunate that many retail investors/traders often end up losing a lot of money when they try to invest or trade with their own money. While there are many reasons for this, one of most significant is a trader’s inability to properly manage risk. Risk/reward is a fairly common term in financial speak, but what exactly does it mean? Well, quite simply, placing your hard earned money into the markets has a certain element of risk, and it should only be fair that if you’re placing your money at risk there should be an element of compensation on the table for taking that risk. Let’s look at it this way; Say a friend of yours asks to borrow $50 and in return they’ll pay you back $60 in a week. Is this worth it to you? Well, how about if they offered to pay you back $100 for the same $50 loan? The risk of losing that initial $50 in order to make $100 is a lot more appealing than the initial $60!
What we have in the above example is a 2:1 risk/reward, a ratio in which is quite appealing to traders and investors because it implies that there’s the potential to double their money. Similarly, if someone was to offer you $200 for the same $50 load, then the risk/reward ratio would go to 4:1.
So let’s have a closer look at this in relation to the forex market. So you’ve been checking out the markets and you’ve found a decent trade setup for say, AUDNZD. For the sake of this article let’s assume that AUDNZD is trading at $.70755, down from its previous high of $.72755. Now you have $500 to invest, so you buy $500 worth of contracts.
So, let’s forget about a stop loss for now and assume we’ll take profit at previous highs, which represents a 2.83% increase in equity. Without a stop loss our RR ratio is 0.0283:1. Now, as implied by the lack of a stop loss, we’re risking 100% of our balance in order to make 2.83% profit. Ok, so let’s try it again with a stop loss that’s 1% of our equity which is approximately $.7005. So now we have an entry price of $.70755, a TP of $.72755 and an SL of $.7005. Now our risk/reward ratio is a much more attractive 2.84:1. This represents almost 3x profit potential vs loss potential.
Any trader or investor worth their weight is aware that relying on ‘hope’ is their ultimate undoing which is why they’re all-too-often conservative with risk/reward.
To apply principles of risk/reward to forex trading, you can follow these steps:
1 -Select your trading instrument/pair using your proven trade strategy.
2 -Choose your upside and downside target areas based on your system and the current price levels.
3 -Calculate the risk/reward ratio.
4 -If the risk/reward ratio is outside your threshold, then move on to the next trade setup.
When you start to incorporate risk/reward into your trading, you’ll notice that it becomes more and more difficult to find decent trade ideas. This isn’t a bad thing, because you’re refining your selection criteria to the trade ideas that ONLY fit your risk/reward profile. The more careful and meticulous you are, the better your chances at making money trading forex.
The final thing you need to remember over the duration of your trade is that the upside potential/number is likely to change as you continue to analyse the new information regarding your setup. If at any time, if the risk/reward becomes unfavourable, don’t hesitate to cut the trade. Never allow yourself to be in a situation where the risk/reward is not well and truly in your favour.
Source: Vantage FX Blog