Risk Reward Ratio in Forex Trading
Risk reward ratio in Forex trading measures how much potential reward/profit you can earn for every dollar you risk. Most investors and traders use a risk to reward ratio to manage their capital and risks. It is calculated by the difference between stop-loss and take profits.
Let’s say your risk to reward ratio is 1:5. It indicates that you’re willing to risk $1 to earn $5. In other teams, if you risk 100 pips and your profit target is 200 pips, then your risk to reward ratio is 1:2.
The formula to measure risk to reward is very simple.
Risk/reward ratio = (entry price - stop loss) / (profit target- entry price)
You can easily measure with this formula but there are also other factors that we need to consider before calculating the correct risk to reward ratio for our trades. Let’s find out how we can measure it properly.
How to Calculate Risk to Reward Ratio in Forex Trading
1. Spread & Risk to Reward Ratio
While trading and calculating risk reward ratio, you must consider the spread by your broker.
Let’s say for EURUSD scalp trade, your stop loss is 10 pips and take profit is 20 pips.
Now if your broker adds 5 pips spread, you’ll be risking 15 pips (10+5) to make 25 pips (20+5).
According to the previous formula, our risk to reward ratio should be 1:2. But now with the spread, it’s 1:1.67
Spreads can make a great impact on scalpers and day traders but they have a less impact on swing and day traders who trade on longer timeframes.
When scalping, a high spread can easily confuse the actual risk to reward ratio of your trades, especially if you select tight stop losses and take profit.
2. Win Rate & Risk to Reward Ratio
Your win rate in trading plays a vital role in risk to reward analysis.
If you already know your trading strategy’s historical risk to reward ratio, you can use a simple calculation to determine the minimum risk to reward ratio you need to stay profitable in the long run.
Required Minimum Risk to Reward Ratio = (1 ÷ Win Rate) – 1
If you win rate is 30%, then you risk to reward should be –
Minimum Risk to Reward Ratio = (1 ÷ 0.3) – 1 = 2.3
You need to maintain 1:2.3 to stay profitable in the long run.
3. Tools to Calculate Forex Risk to Reward Ratio
There are built in tools in most trading platforms like Metatrader4. It’s called the Fibonacci retracement tool. You can use it to measure the risk reward ratio in Forex trading easily.
When you’re trading volatile markets like Forex or commodities, there’s a higher chance of losing money. A proper balance between risk and reward can help you become successful in Forex easily. No matter how you calculate your risk reward ratio in Forex trading, it is very important to take your time to measure your risk reward ratio properly.