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The risk/reward ratio in Forex is the prospective rewards you will earn for every dollar you risk. This can be used to compare the expected returns in the Forex market to the risks you will undertake. For example, if your risk/reward ratio is 1:7, it means that you are willing to risk $1 for prospective earnings of $7.
If you could exchange one orange for two apples, and they both cost $1 each (both apples and oranges), is it a good decision? Even considering that the apples have a chance to become rotten? This is the question that many Forex traders face on a daily basis, but instead of fruit, it’s currencies. That’s why we’ve created this risk/reward ratio guide, to finally answer this question.
Every trader is different in terms of the risks they are able and willing to endure. Today, we are going to discuss different types of risk/reward ratios in Forex trading and will help you find the ratio that fits your needs the best.
When it comes to Forex trading, there is an increased chance of losing money because of its high-risk nature. For the best outcome, even the top FX traders adopt risk/reward ratios to control the risks they take.
The risk and reward ratio in Forex trading is different for every trader. There are some who enjoy high-risk trading, while others are doing everything they can to cut down on the risks they are exposed to.
Many traders use the risk-reward ratio as a metric to calculate how much they are risking in the market. There are different types of risk/reward ratios traders adopt. Mostly, it is believed that a risk/reward ratio above 1:3 is good for Forex trading.
But, it is not the same for everyone as high-risk trades and losses can be demotivating for many traders. But, the risk/reward ratio on its own is not really able to provide traders with any actual information. On the other hand, this paired with the payout rate could be a really helpful indicator of what to expect.
This way, it becomes much easier for traders to calculate the success of their trading strategy in the long run. We will discuss this later in the guide.
A general rule of thumb when coming up with a risk/reward ratio is to not risk more money than you can afford to lose. For example, let’s say that you are using a 1:3 risk/reward ratio. This means that for every $300 in profits, you can afford to make a loss of $100, or for every $3,000, you can risk losing $1,000, and so on.
Many traders are using the ratio of risk/reward in Forex trading while looking for their ideal trading strategy. But, as we have already noted, this metric is simply not enough to provide traders with the right amount of information about the long-term prospects of their positions and strategy.
What many traders are doing is pairing this ratio with a payout rate, which can be quite helpful for Forex traders when determining what strategy to use for the best possible outcome.
A very good formula that can help you calculate the risk/reward ratio with the payout rate is the following:
It might look a bit complicated, but it is really a very easy formula to follow. Here 'P' is the success rate, 'X' is the size of the average payout, 'Y' is the size of the average loss, and 'Z' is the payout rate.
Based on these basic metrics, you can easily calculate the success rate of your trading. So, let's say that you made 100 trades in total, and 20 of them were not successful, while 80 managed to bring you profits. This means that you had a success rate of 80 percent. This could be a very useful metric for checking if a certain trading strategy is good in the long run or not.
If you want to calculate the risk/reward ratio alone, you would simply look at the profits that you have made and the money that you have lost. Let’s say that you have lost $100, but made $300. This would take your risk/reward ratio to 1:3.
It is fairly hard to say that there is one risk/reward ratio that every trader should be using, but there are some unwritten rules that could come in handy. One of the best risk/reward ratios to use for Forex trading is 1:3.
This ratio is not too high but can bring in respectable profits. This is considered to be a great balance for Forex traders to continue making good profits, while also not risking a lot of their investments.
To be fair, the absolute best risk/reward ratio is anything that works well with your personal trading strategy while still making a profit. But, to make sure that your strategy is profitable in the long run, you should be risking your capital for a lower risk/reward ratio.
This means that you will not be risking losing more than a fourth of your final profits. Losing half of your investment, or even more, is not really a good thing for long-term investment.
Additionally, if you are using leverage - which is used very actively in the Forex trading market - your losses can be further increased, and you can end up in a margin call or stop-out situation. Thus, it is important to think twice before you decide how much money you are willing to risk.
For some traders, it is hard to understand the true meaning behind risk/reward in Forex. This mainly happens because they find it hard to understand where to use it and how to apply it to actual trading. In the Forex trading market, the risk and reward ratio can be directly seen as the type of order you open.
There are numerous different order types in Forex, and these include smart orders. For example, stop orders are a great way for traders to make sure that they are not losing more than they can afford. By using the risk/reward ratio, you can know exactly how much money you can afford to lose. Stop orders help traders close their positions once the asset reaches a specific price point, ensuring that their risk/reward ratio is strictly followed.
The most popular such orders are stop-loss and take-profit orders. A stop-loss order closes the positions when you have taken a specific amount of loss, while a take-profit order closes out your trades once you have gathered the profits you have been looking for.
Depending on your risk/reward ratio, you can set the stop-loss and take-profit orders so that you stay safe no matter what happens in the market. Even if there is massive market news that causes huge price fluctuations, you will be kept safe with these smart orders executed, and you won't lose more money than your risk/reward ratio allows for.
As we have already said, not every trader is using the same ratio of risks and rewards. In fact, this is a very personal decision that every trader makes according to their goals. In most cases, more experienced traders are using ratios that are not too focused on minimizing the risks, as they are capable of risking more money, and therefore tend to focus more on the potential rewards.
On the other hand, if you are a total beginner in the market, it is much better to risk as little as possible and slowly move on to opening riskier positions when you increase your trading knowledge and skills.
Below, we will discuss some examples of risk/reward ratios. So, keep reading to see which one fits your personal needs the best.
There are many traders in the Forex trading market that enjoy using a risk/reward ratio with higher amounts of risk. There are many advanced traders in the market who are using lower risk/reward ratios, for example, 1:1, 1:2, and so on. These ratios have the highest risks as they have the least potential for good returns. For example, 1:1 means that for every $100 profit, you are ready to risk $100 in losses.
This can be quite dangerous because you can very easily lose a lot of money. 1:2 means that for every $100 profit you hope to make, you are ready to risk losing $50. Even this is considered to be a high-risk strategy. However, experienced traders use these types of ratios only when they are confident in their positions, hoping for the higher risks to pay off.
These risks can increase even further. Forex trading is known for offering traders higher leverage than other markets. Many traders in Forex are taking advantage of this offering in the hopes of making higher profits, but this can actually increase their risks even further, leading to even higher losses.
In the Forex trading market, there is always some type of risk involved. In fact, it is almost impossible to imagine this market without risk. But remember, taking such high risks can be quite dangerous for beginner traders, and many newbies taking on such high risks end up losing all their money without ever seeing a return.
It is very common for beginner traders to opt for a risk/reward ratio that can guarantee higher wins while keeping the risks to a minimum. In general, anything above 1:3 is considered to be an acceptable risk/reward ratio for beginners.
But, many beginners go with even higher ratios, like 1:7, or even 1:10. While this can also decrease the chances of making high profits, it can help traders to make sure that they are not losing a lot of money.
The 1:7 ratio means that for every $700 profit, traders are risking losing $100. This type of ratio of risk and reward can help traders trade currency pairs while also focusing on the further development of their skills in the market, while not risking a lot of their funds.
In addition, those looking for ways to cut down the risks of Forex trading are also very likely to be using lower leverage. Generally, beginner traders use the leverage of 1:10 or 1:20, to make sure that they are not losing more money than they can afford.
The Forex risk/reward ratio is a very important thing that beginners, as well as experienced traders, should always keep in mind. There are many things that make the risk/reward ratio important for Forex traders, such as the fact that it can help traders better plan their positions.
As we have already mentioned, risk/reward ratios can be helpful for traders to set stop-loss and take-profit orders, which can save traders from unwanted losses in the market. Paired with a payout rate, it can also be useful for traders to determine the long-term effectiveness of the strategies they are using.
Simply put, the risk/reward ratio can help traders better understand their future positions and the profits they can make in the Forex trading market.
A 1:3 risk/reward ratio or above is considered to be good for Forex traders. Many people believe that this is an ideal risk/reward ratio for traders. The risks in the Forex trading market can be managed directly by using stop-loss and take-profit orders. A 1:3 risk/reward ratio means that for every $300 profit made by traders, they are willing to lose $100. While this is considered to be a good risk/reward ratio, there are some traders who like taking higher risks while trading.
Forex risk/reward ratio is calculated by dividing the difference between the entry point of a trade and the stop-loss order, which is the risk, by the difference between the targeted profit and the entry point, which is the reward.
But, if you want to determine how useful a strategy is for you over the long term, you should also calculate the payout rate. For this, traders use the following formula: P = (1+(X/Y)) x Z - 1. Here, P is the success rate, X is the size of the average payouts, Y is the size of average losses, and Z stands for the payout rate. This way, you will be able to calculate the success rate of your strategy in the long run.
A 1:1 risk/reward ratio is a risky way of trading. This means that you are ready to risk $100 of loss for every $100 profit you make. The overall win rate for this ratio is about 50%, which can make trading quite risky. This paired with high-leverage usage can further increase the risks of FX trading.