Risk reward, is the trade really worth doing?
Understanding the risk reward ratio of all your trades is a must have parameter of any sensible money management strategy.
It is all too easy to lose money trading the Forex. If you trade far too high a percentage of your account at once, before you know it, after only a few hard hitting trades your pot is empty. Or you might well have a high percentage of small winning trades, then along comes a large loosing trade that again wipes you out leaving the pot empty and you wondering what happened.
As risk is a part of every trade it is a must for every trader to work out what he/she stands to gain versus their loss before you hit the buy button.
This means a trader should know, before taking a trade, how much of your capital are you willing to lose versus the potential reward or amount you stand to win if the trade comes good.
It's easy to work out so let’s look at a few examples.
If the ratio is say 1:2 then for every unit you would potential loss you will be looking for a return of two units. So if you have set your stop loss order 20 points/pips away from your opening order then you would be looking for a gain of at least 40 points/pips.
If the ratio is 1:3 then for every 3 unit you would potential loss you would be looking for a return of three units. Again if you have set your stop loss order 20 points/pips away from your opening order then you would be looking for a gain of at least 60 points/pips.
Setting your parameters at 1:2 ratios is the leased you should be looking for. To put that into some context it would mean that if you were successful on 40% of your trades, which is not so out there, then in the long run you will be a profitable trader. "Wow that's less than half my trades and I can still be profitable" Yeah well that kinder reduces the pressure a bit doesn't it. This is where we go back to our psychology again, patience and self-control. Also how great is it to hear someone actually tell you that you don't have to be right all the time?
"Let your profits run and cut your losses quickly"
"Which risk-reward ratio should I be using?"
Whether you look for a return of two, three, four or even five times your potential loss is really down to you but as we have looked at 1:2 is a good starting point for beginners. Then as you become more experienced build on that and you will find that some trades offer more easily to three to four times your potential loss but always make the goal two. If you don't you will be just gambling your hard earned money away. Remember if the trade is not worth doing then be patient there will soon be one that is worthy of risking your money.
Return from Risk Reward back to Money Management