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Risk Reward Ratio

Risk-Return Ratio

Risk-Return is a very important concept that a trader must understand and implement in order to be profitable trading the Forex market.  The concept of Risk-Return, as its name suggests, quantifies the ratio of the expected loss (if the trade is unsuccessful) to the expected gain (if the trade IS successful).  When combined with the probability associated with a trade’s outcome, proper use of risk-return will significantly increase a trader’s chances of success.

Risk-Return is a very important concept that a trader must understand and implement in order to be profitable trading the Forex market.  Wait – did I repeat myself?  Yes – the concept is that important!!  Now read on…

While this ratio is commonly called “Risk-Return,” the actual numerical ratio is conventionally written backwards.  As an example, a 2:1 Risk-Return ratio indicates the trader expects either 2 units of profit/return, OR 1 unit of loss/risk.  In this example, a “unit” can be a dollar, a pip, or any other measure – it doesn’t matter as the calculation is a ratio.

How is Risk-Return Determined?

For each and every trade made the following two questions should be asked (BEFORE the trade is placed):

1)    IF I am correct, and the trade is profitable, how much can I expect to earn?

2)    IF I am wrong, and the trade is a loss, how much am I willing to lose?

The answers the these questions will determine the Risk-Return Ratio for that given trade. 

Example:

Suppose I see a great opportunity to buy the EUR/USD at 1.3200.  IF my analysis is correct and the trade goes my way I can reasonably expect to see the pair go all the way to 1.3400.  If this happens, I will earn 200 pips – this is my target, or my expected return.

However, IF my analysis proves wrong and the trade goes against me I am only willing to lose 50 pips.  I will set my Stop Loss order at 1.3150, establishing a maximum risk of 50 pips.

Risk-Return Formula:   Expected Return  /  Maximum Risk

Our Example:  200 pips  /  50 pips  =  4

Our Risk-Return Ratio: “4:1”

Combining Risk-Return and Probability

Risk-Return Ratio is only part of the profitability equation.  The other important factor that must be considered is probability.  Probability answers the question: “What are the odds this trade will reach its target?”

Purely random events – like a coin toss – will have a probability of 50%.

A more probable outcome will be over 50%, while an unlikely outcome will be less than 50%.

To show the relationship between Risk-Return and Probability, let’s ask ourselves a question:

If I make 4 trades in a day, what Risk-Return and Probability do I need to breakeven?

To work through this example, let’s say we are only taking trades that have a 3:1 Risk-Return.  This means that every trade I win – I earn $3.  Every trade I lose – I lose $1.

risk reward ratio

risk reward stats

In this example, a 3:1 Risk-Return Ratio, combined with a winning probability of 25%, allowed us to breakeven at the end of 4 trades.

Below is a table of the Risk-Return and probability combinations needed to breakeven.

risk reward probability

How to Use Risk-Return

What is the best Risk-Return Ratio?  The largest of course!  But the minimum Risk-Return Ratio absolutely necessary will vary for each trader.  To determine the Risk-Return Ratio that will increase your profitability, ask yourself this question:

What percentage of the time are my trades successful?

If your answer is 50%, you only need a Risk-Return slightly higher than 1:1.  If your trades are only successful 20% of the time, you need at least a 4:1 Risk-Return.

As a general rule of thumb, it is very difficult to achieve a winning rate greater than 50%.  Therefore, most profitable traders aim for Risk-Return trades that are 2:1 as an absolute minimum, while 3:1 or 4:1 is strongly suggested.