When it comes to trading in the forex market, one of the most important concepts to understand is the risk reward ratio. This ratio is used to determine the potential profit or loss that can be expected from a trade, and it forms the basis of many trading strategies. In this article, we will discuss how to calculate the risk reward ratio in forex.
Understanding the Risk Reward Ratio
The risk reward ratio is a simple calculation that compares the potential profit of a trade to the potential loss. It is expressed as a ratio, with the potential profit being the numerator and the potential loss being the denominator. For example, if a trade has a potential profit of $100 and a potential loss of $50, the risk reward ratio would be 2:1.
The risk reward ratio is an important tool for traders because it helps them to assess the potential profitability of a trade in relation to the potential loss. A high risk reward ratio means that the potential profit is much greater than the potential loss, while a low risk reward ratio means that the potential loss is greater than the potential profit.
Calculating the Risk Reward Ratio
Calculating the risk reward ratio is a straightforward process. To do so, you need to determine the potential profit and potential loss of a trade. Let’s take an example:
Suppose you want to trade the EUR/USD currency pair, and you believe that the price will rise from its current level of 1.1200 to 1.1300. You decide to buy 10,000 units of EUR/USD at 1.1200, with a stop loss order at 1.1150. This means that if the price falls to 1.1150, the trade will automatically be closed to limit the potential loss.
Now, let’s calculate the potential profit and potential loss of this trade.
Potential Profit: The potential profit is the difference between the entry price and the target price. In this case, the target price is 1.1300, so the potential profit is:
Potential Profit = (Target Price – Entry Price) x Number of Units
Potential Profit = (1.1300 – 1.1200) x 10,000
Potential Profit = $100
Potential Loss: The potential loss is the difference between the entry price and the stop loss price. In this case, the stop loss price is 1.1150, so the potential loss is:
Potential Loss = (Entry Price – Stop Loss Price) x Number of Units
Potential Loss = (1.1200 – 1.1150) x 10,000
Potential Loss = $50
Now that we have calculated the potential profit and potential loss, we can calculate the risk reward ratio:
Risk Reward Ratio = Potential Profit / Potential Loss
Risk Reward Ratio = $100 / $50
Risk Reward Ratio = 2:1
In this example, the risk reward ratio is 2:1, which means that the potential profit is twice the potential loss. This is a good risk reward ratio, as it means that the potential profit is greater than the potential loss.
Using the Risk Reward Ratio in Forex Trading
The risk reward ratio can be used in forex trading to help traders make informed decisions about their trades. A high risk reward ratio is generally considered to be favorable because it means that the potential profit is greater than the potential loss. However, it is important to note that a high risk reward ratio does not guarantee profitability.
Traders can use the risk reward ratio to set their profit targets and stop loss levels. For example, in the example above, a trader may decide to set a profit target of 1.1300 and a stop loss level of 1.1150, based on the risk reward ratio of 2:1.
Traders should also consider other factors, such as market conditions, trends, and technical analysis, when making trading decisions. The risk reward ratio is just one tool that traders can use to assess the potential profitability of their trades.
Conclusion
The risk reward ratio is a simple but powerful tool that traders can use to assess the potential profitability of their trades. By calculating the potential profit and potential loss of a trade, traders can determine the risk reward ratio and use it to make informed trading decisions. While a high risk reward ratio is generally considered to be favorable, traders should also consider other factors when making trading decisions.
