When you first start trading one of the difficulites new traders have is calculating the risk to reward ratio, or better yet just sticking to their R&R plan. If you can master your risk to reward you really can turn a small account into a large account in due time. Having paitence and discipline to ride out your winning trades or close those losing trades quick will also ensure that your account is grown at a healthy rate.
What is a Risk-Reward Ratio?
The risk-reward ratio is simply a calculation of how much of your capital you are willing to risk per trade, versus how much you plan to go for as your profit target. In simple terms, if you were taking a trade and you have a 5 pip stop loss and your take profit is 20 pips, you are risking five pips for the chance to gain 20 pips and your risk-reward ratio would be 1:4.
How to Use a Risk-Reward Ratio in Forex Trading
One fo the key factors to being profitable in forex is to have a good R&R strategy. If your trading strategy only lets you take 1:5 Risk to Reward trade then you could take 4 losses and 1 win to break even. The idea being that you look for trading opportunities that offer the lowest risk to highest reward ratio and stick to that plan to make sure that your account grows with your confidence. The idea of using a good risk-reward ratio is to put the odds in your favor. If you consistently did the 1:5 ratio, you could lose half of your trades, and still, make a decent profit.
Typically, risk-reward is useful when the price is near important suppley and demand zones. For example, if EUR/USD is in a downtrend and price has stalled near resistance and could be posting a lower high, the risk: reward would likely favor a sell trade with a smaller protective stop above the entry and a larger take profit in the direction of the trend.
Entering on pullbacks in the direction of trend can also be a great way to ensure a high probablity trade offering a good R to R ratio.
Any way that look into it , you need to have a good R to R strategy to add to your trading arsenal.