Risk : Reward ratio

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Posted by on Tuesday August 23, 2011 15:1:55:

What risk to reward ration do you use when you open a position in your trade? Risk in an inherent factor a forex trader has to face daily in his trade. You may get the analysis right and infact you might even be able to use a lot of indicators to confirm that you are on the right path but what finally happens to currency prices will ultimately depend on the invincible forces of demand and supply. Forex currency pricing is not perfectly predictable so professional traders are aware of this that's why they use certain tactics to limit any unforseen losses they may get in their open trades.
Stop loss is one of such tools and it allows the trader to set a minimum price beyond which his position(buy or sell) would automatically close. A stop loss is actually a point or price at which you just cut short your losses and it is normally measured in pips. Now assuming you buy some EUR/USD at 1.4530 and place a stop loss at 1.4400(which is 30 pips) but unfortunately, the price goes against you and even falls to 1.4300(100 pips). Since you have used a stop loss, you would be protected from an additional 70 pips loss so using a stop loss for every position you open is a must for a professional trader since with a stop loss, you have limited your risk.
Now let's go on to rewards. A reward is something you gain when a position favours you and your speculations are right. If like in the above scenario, you also placed a take profit or exit target at 1.4560(30 pips) and the price goes up above your profit target, then your buy or long position will automatically be closed and you would be credited with 30 pips.

Now we all know that predictions in forex are not perfect and market can go crazy at times, so using a stop loss and target point are some of the tactics you can use to get in and get out of a trade smoothly. Now assuming we have 20 trading days in a month and for the first 10 days, your speculations are right, you would probably gain 300 pips but if for the remaining 10 days you also lose 300pips then it means at the end on the trading month, you have made zero pips or profit. This is mostly likely the case for people who make as much loss as they gain and still do not use an appropriate Risk:Reward ratio.

The basic kind or Risk to reward ratio you should be using is a 1:2 which simply means that for every 1 pip you risk, you should reward yourself with 2 pips at least. You may even decide to use a 1:3 or 1:4 if you like but the basic if 1:2. This would make you more rewarded for your gains but less punished for your losses. No need crying over spilled milk so if someone loses in forex, he should not have to lose more than what he gained.

Now here is what a 1:2 risk to reward ratio will do for you using the above scenarios:
If in a month you win 10 trades and lose 10 trades you would, because of your 1:2 strategy, only lose 300 pips but gain 600 pips. Now this will give you a balance of 300 pips to rejoice about assuming you stick to the 30 pips a day trade.

So this means that assuming you:
Buy EU/USD at 1.4530
Set exit target at 1.4560 (30 pips * 2)
Also set stop loss at 1.4500 (30 pips * 1)

You would be gaining 60 pips for every win and 30 pips for every loss so this is a good setup that can make you a professional forex trader in a short while