How to Use Risk to Reward Ratio in Forex Trading

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Although the forex market is highly liquid, learning risk management is a fundamental step to becoming a profitable trader. Strategies like implementing a stop-loss trading strategy and evaluating the risk-to-reward ratio can help traders increase their win rate. In the article, Benzinga discusses what the risk-to-reward ratio is and how you can use it in forex trading. 

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What is a Risk-to-Reward Ratio?

The risk-to-reward ratio is a comparison of a trade’s potential losses and profits. It is derived by dividing the amount of investment by potential profits. Understanding the risk-reward ratio can be challenging for beginners. 

To keep it simple, think of it like this: a risk-to-reward ratio of 1:5 means the investor may be willing to risk $1 to earn $5. In a live forex market, this is done by first identifying the following: 

• Trade entry point: The price at which a trader enters into a trade. 
• Stop loss: Designed to limit potential losses. It closes a position when the market reaches a specific point.
• Profit target: A predetermined point at which an investor chooses to exit a trade for positive gains. 

Importance of Maintaining a Favorable Risk-to-Reward Ratio

Those involved in day trading must understand that setting and maintaining a favorable risk-to-reward ratio is critical to their investment strategies for a number of reasons. Some of them include: 

Objective Analysis 

A risk-reward ratio can help traders analyze their trades more objectively based on mathematical calculations alone. This process helps determine the level of risk involved with earning predefined profits. It can also help remove subjective elements like preferability or personal opinions from trading decisions. 

Precise Stop-loss Points 

A stop-loss point is set to limit potential losses by closing a trade at a predefined point. Analyzing the risk factor helps determine precise stop-loss points. Using the risk-to-reward ratio can help traders determine the risk associated with each trade.

Quick Reevaluation

The performance of currency pairs in forex trading can be influenced by a number of factors, including geopolitical or economic developments. In such cases, using the risk-to-reward ratio can help traders quickly analyze the risk and potential profiles associated with certain trades. It may also help them make decisions that increase the possibility of a greater return. 

How to Calculate Risk-to-Reward Ratio in Forex Trading?

To calculate the risk-to-reward ratio in forex trading, you must know the entry price, stop-loss point and profit target. Once you’ve figured out all these metrics, you can use the formula below to calculate the ratio.

Risk to Reward Ratio = (Entry Price - Stop Loss Value) / (Entry Price - Profit Target)

Determine the difference between the entry price and stop loss value. After that, calculate the difference between the entry price and the profit target. Then divide the two differences to get the risk-to-reward ratio.

Example of the Risk-to-Reward Ratio in Use

Now, let’s use an example to better understand how the risk-to-reward ratio works in the forex market. Using the EUR/USD currency pair, the values are:

• Entry price - 1.3
• Stop loss - 1.2 
• Profit target - 1.5 

When putting these values into that formula, you need to figure out the pips between them. A pip is a standardized unit that measures the change in the forex market where a change of 0.1 equals 100 pips. So for this example, the pip for the entry price and the stop loss would be 100, and for the entry price and profit target, 200. With this in mind, the formula will look like this: 

Risk to Reward Ratio = (100) / (200)

Based on these calculations, the risk-to-reward ratio of 1:2, which indicates that the hypothetical trade has low risk and could generate profit.

Strategies for Improving Risk-to-Reward Ratio

Using the risk-to-reward ratio could possibly help traders reduce risk. It may also help increase the potential for profit. It’s a major step towards becoming a day trader. Strategies that traders use to improve their risk-to-reward ratio calculations include:

Realistic Profit Targets 

When using the risk-to-reward ratio, you have to set realistic targets. If your profit targets are too high, the risk will also increase and your trading decisions could be inaccurate. Using realistic profit targets may help lower the risk, allowing you to choose positions that could be more profitable.

Effective Stop Losses 

Setting stop losses may help exit a trade before you incur major losses. When setting stop-loss points, the level should not be how much you’re willing to lose. Instead, your stop-loss points should be just below the moving average. This practice may help minimize the risk associated with a particular trade. 

Take Profits 

Knowing when to take profits and exit the market is critical. This point should determine your risk-to-reward ratio. If the ratio is 1:2 and your stop loss is 20 points, exiting the market at 40 points of profit may be an effective approach. 

Reevaluate Your Ratio

Market changes in forex are influenced by geopolitical or economic factors. To make the most of your risk-to-reward ratio, you need to constantly reevaluate it. You should reconsider your entry, exit and stop-loss positions based on market changes and calculate the risk accordingly. 

Want to Use Risk-to-Reward Ratio?

To sum it all up, the risk-to-reward ratio can help day traders manage their risk better. Using that ratio allows traders to determine the level of risk associated with desired profits and may help them make informed decisions. However, your decision to use the ratio and its effectiveness depends on your trading experience and market understanding. 

Frequently Asked Questions

Disclosure: Benzinga was commissioned for this article and is not affiliated with LonghornFX. Any comments or opinions provided herein are Benzinga's. LonghornFX does not endorse or promote any trading strategies that may be discussed or promoted herein. The broker makes no representation or warranty as to the article's adequacy, completeness, accuracy or timeliness for any particular purpose of the above content.

This presentation discusses technical analysis, other approaches, including fundamental analysis, may offer very different views. The examples provided are for illustrative purposes only and are not intended to be reflective of the results you can expect to achieve. This article is for informational and educational use only and is not a recommendation or endorsement of any particular investment or investment strategy. Investment information provided in this content is general in nature, strictly for illustrative purposes, and may not be appropriate for all investors. Investing involves risk regardless of the strategy selected and past performance does not indicate or guarantee future results. Trading leveraged products such as Forex and Cryptos may not be suitable for all investors as they carry a degree of risk to your capital.