Forex trading is a risky business, and as such, it is essential to know how to calculate risk and reward before every trade. Risk and reward are two of the most critical elements of forex trading, and they play a huge role in determining the profitability of a trade. In this article, we will explain how to calculate forex risk and reward, and why it is crucial to do so before every trade.
What is Forex Risk?
Forex risk is the potential loss that a trader may incur when trading forex. It is the probability of losing money on a trade. Forex risk can be caused by a range of factors such as market volatility, economic events, geopolitical issues, and trading errors. Forex risk can be classified into two main types:
1. Systematic Risk: This is the risk that is inherent in the forex market. It is the risk that arises from macroeconomic factors such as interest rates, inflation, and geopolitical tensions.
2. Unsystematic Risk: This is the risk that is specific to an individual trade. It is the risk that arises from factors such as market volatility, technical analysis, and trading errors.
Calculating Forex Risk
To calculate forex risk, you need to consider two essential factors: the size of your trading position and the distance between your entry price and your stop-loss level.
1. Position Size: This is the amount of money you are willing to risk on a trade. To calculate your position size, you need to consider your account balance, risk tolerance, and the size of your stop-loss.
2. Stop-Loss: This is the price level at which you will exit the trade if the market moves against you. To determine your stop-loss level, you need to consider the volatility of the currency pair you are trading, the size of your trading position, and your risk tolerance.
Once you have determined your position size and stop-loss level, you can calculate your forex risk using the following formula:
Forex Risk = Position Size x (Entry Price – Stop-Loss Price)
For example, if you are trading EUR/USD with a position size of $10,000 and your entry price is 1.2000, and your stop-loss price is 1.1900, then your forex risk would be:
Forex Risk = $10,000 x (1.2000 – 1.1900) = $100
What is Forex Reward?
Forex reward is the potential profit that a trader may earn when trading forex. It is the probability of making money on a trade. Forex reward can be caused by a range of factors such as market volatility, economic events, and trading strategies. Forex reward can be classified into two main types:
1. Expected Reward: This is the potential profit that a trader expects to make on a trade. It is calculated by multiplying the expected return of the trade by the position size.
2. Actual Reward: This is the actual profit that a trader makes on a trade. It is calculated by subtracting the entry price from the exit price and multiplying the result by the position size.
Calculating Forex Reward
To calculate forex reward, you need to consider two essential factors: the size of your trading position and the distance between your entry price and your take-profit level.
1. Position Size: This is the amount of money you are willing to invest in a trade. To calculate your position size, you need to consider your account balance and risk tolerance.
2. Take-Profit: This is the price level at which you will exit the trade if the market moves in your favor. To determine your take-profit level, you need to consider the volatility of the currency pair you are trading, the size of your trading position, and your risk tolerance.
Once you have determined your position size and take-profit level, you can calculate your forex reward using the following formula:
Forex Reward = Position Size x (Take-Profit Price – Entry Price)
For example, if you are trading EUR/USD with a position size of $10,000 and your entry price is 1.2000, and your take-profit price is 1.2100, then your forex reward would be:
Forex Reward = $10,000 x (1.2100 – 1.2000) = $100
Why Calculate Forex Risk and Reward?
Calculating forex risk and reward is essential for several reasons:
1. Risk Management: Calculating forex risk and reward helps you manage your risk effectively. By knowing your potential risk and reward, you can determine whether a trade is worth taking or not.
2. Profitability: Calculating forex risk and reward helps you maximize your profitability. By taking trades with a favorable risk-reward ratio, you can increase your chances of making a profit.
3. Consistency: Calculating forex risk and reward helps you maintain consistency in your trading. By using a systematic approach to calculate your risk and reward, you can avoid impulsive trades and stick to your trading plan.
Conclusion
Calculating forex risk and reward is an essential aspect of forex trading. By knowing your potential risk and reward, you can make informed trading decisions and manage your risk effectively. Remember, forex trading is a risky business, and risk management is crucial for long-term success.
