A simple fact about trading forex is that the market is merely a game of probabilities.
Interestingly, traders who continuously make profits in forex are those that learn to think and view the trade setups according to the risk to reward manner.
There’s an element of risk while trading forex, but at the same time, the potential for high rewards is also great.
Therefore, it can be said that successful forex trading is all about finding the right balance between the risk and the expected outcome.
Unfortunately, most forex traders are so much preoccupied with getting a profitable forex strategy that they even forget about the significance of an excellent risk to reward ratio.
Perhaps, most traders would consider a high win rate than taking on asymmetric returns.
To better understand the risk to reward ratio in forex, you have first to understand what constitutes reward, and what constitutes a risk.
The Concepts of Risk
When looking at the risk in forex trading, it has to incorporate the leverage used in all trades, stops in trade protection, and the trade volume.
Leverage in forex is meant to increase a trader’s capital and hence increase the trade volume to magnify the value of pip movements.
As much as leverage is excellent that it can magnify the profits, it can as well expand the losses.
The stop loss is another element of risk used as trade protection. The magnitude of risk a stop loss has to trade is equal to the lot size in that trade as well as the number of pips in setting the stop loss.
The Concept of Reward
The reward in forex is merely the expected outcome of a trade, and it’s a product of leverage, trade volume, and the take profit.
The outcome of a trade-in forex trading is the product of the pips a trade moves in the direction a trader chooses.
Therefore, several pips have to be aimed at before an asset reverses its movement. Also, the trade volume has a say on the reward volume.
How to Use Risk and Reward When Trading Forex
A right balance between risk and reward ratio is what determines the profitability of a trader in forex trading. Therefore, to make profits, the rewards have to outdo the risks.
The most important thing in forex is to ensure that the combined profits form profitable trades exceed the losses from losing trades.
It doesn’t matter whether the losing trades are more than the number of profitable trades.
Therefore, a trader should always trade where the profit potential is high then the potential loss.
In that case, trades delivering a minimum of 3 pips potential profit for every one pip potential loss should be the ones to be executed.
To set such targets, the support and resistance levels of a prevalent chart have to be considered accordingly.
The closest support should guide set the stop loss while the nearest resistance guide set the profit target. At the minimum, a risk to reward ratio of 2:1 is acceptable.
The Bottom Line
The type R/R ratio you decide to use is always dependent on the type of trader you are as well as the market conditions. However, the ideal scenario is to find trades with high rewards and low risk.
The market should not take more from the trade than you’re looking to choose from the market. Always enter as well as exit the market according to your terms.