The risk reward ratio is a crucial tool for forex traders as it helps them to determine the potential gains and losses of their trades. It is a simple calculation that measures the amount of risk taken in relation to the potential reward. The risk reward ratio is calculated by dividing the amount of risk by the potential reward. This article explains in-depth how the risk reward ratio is calculated in forex trading.
Calculating Risk
The first step in calculating the risk reward ratio is to determine the amount of risk in a trade. In forex trading, risk is the amount of money that a trader is willing to lose on a trade. It is important to set a stop loss order to limit the amount of risk in a trade. The stop loss order is a predetermined price level at which a trader exits a losing trade. The stop loss order is set at a level that is comfortable for the trader and is based on technical analysis, market conditions, and risk tolerance.
For example, if a trader enters a long position on the EUR/USD currency pair at 1.2000 and sets a stop loss order at 1.1950, the amount of risk in the trade is 50 pips or $500 if the trader is trading one standard lot (100,000 units). This means that the trader is willing to risk $500 to make a profit on the trade.
Calculating Reward
The next step in calculating the risk reward ratio is to determine the potential reward of a trade. The potential reward is the amount of profit that a trader expects to make on a trade. It is important to have a target profit level in mind before entering a trade. The target profit level is based on technical analysis, market conditions, and risk tolerance.
For example, if a trader enters a long position on the EUR/USD currency pair at 1.2000 and sets a target profit level at 1.2100, the potential reward of the trade is 100 pips or $1,000 if the trader is trading one standard lot. This means that the trader expects to make a profit of $1,000 if the trade is successful.
Calculating Risk Reward Ratio
Once the amount of risk and potential reward are determined, the risk reward ratio can be calculated. The risk reward ratio is calculated by dividing the amount of risk by the potential reward.
For example, in the trade above, the amount of risk is $500 and the potential reward is $1,000. The risk reward ratio is 1:2, which means that for every dollar risked, the trader expects to make two dollars in profit.
Importance of the Risk Reward Ratio
The risk reward ratio is an important tool for forex traders as it helps them to manage their risk and reward. A positive risk reward ratio ensures that traders are making more money on their winning trades than they are losing on their losing trades. This is essential for long-term profitability in forex trading.
A good risk reward ratio is at least 1:2, which means that traders should aim to make at least twice as much profit as they are risking on each trade. This ensures that even if traders have more losing trades than winning trades, they will still be profitable in the long run.
Conclusion
The risk reward ratio is a simple but powerful tool for forex traders. It helps traders to manage their risk and reward by calculating the amount of risk and potential reward in a trade. A positive risk reward ratio is essential for long-term profitability in forex trading. Traders should aim for a risk reward ratio of at least 1:2 to ensure that they are making more money on their winning trades than they are losing on their losing trades.
