The forex market offers numerous opportunities for profit, but not without its fair share of risk. Due to this, risk management becomes a vital part of every forex trade. This is where a trader analyzes the risk they’re willing to take in order to achieve a certain level of profit. For one to be an expert trader, one must know how to calculate this risk and the measures they should take to ensure their success in the trade.
Why should you manage risk?
Many beginner traders have been lucky enough to make profits on their first trade or series of trades. This is not uncommon. Unfortunately, more often than not, a time comes around when one trade results in loss, and not only that, the single loss wipes out all the profits they had accumulated. This is a result of ineffective risk management.
The secret to success in forex is to find that sweet spot between what you risk and what you aim to achieve. You may arbitrarily aim for a 1:3 risk to reward ratio, for example. However, if your trading strategy cannot deliver this level of profit target, most of your trades will be closed out by the stop losses, which nets a loss onto your account. Similarly, if your preferred ratio was 1:5, but you prematurely exit profitable trades before hitting your target, you may be making profits, but you’re essentially leaving money on the table.
Therefore, to obtain the ideal risk to reward ratio, you need to backtest your trading strategy extensively. This way, you will know what kind of results it is capable of producing, and you’ll have a practical risk to reward ratio to guide you when placing trades.
Calculating risk to reward ratio
The method used to calculate the risk to reward ratio is pretty straightforward. When making a trade, you will often put a stop loss in the opposite direction from that which you hope the price will follow. This is the risk you take. The distance from your entry to your stop loss in pips gives the risk part of the ratio.
When placing the trade, you will typically have a profit target, where you predict prices may reach in the future. This is the reward you hope to obtain. The distance between your entry position and your take profit point is the reward part of the ratio. In a nutshell:
R/R ratio = (Entry point – stop-loss point) / (profit target – entry point)
A point to note is that you should always factor in your broker’s spreads and commissions when calculating this R/R ratio. This is because these fees will eat into your profits, if any, or add to your losses if any.
Let’s take an instance of a day trader who aims for a profit ten pips away while placing their stop loss five pips from their entry. At face value, this looks like a 1:2 R/R ratio. However, assuming their broker charges two pips of spread per transaction, the risk becomes 5 + 2 = 7 pips, while the reward becomes 10 – 2 = 8 pips. This means that in actual sense, our trader’s R/R ratio is 1:1.14. Pretty huge difference, right?
The good news is, the effects of trading fees will be less pronounced if you trade on larger timeframes. This means that your trades will span longer periods of time, but then you will be aiming at much larger profits. Let’s take an example of a swing trader taking the risk of 100 pips and aiming at a profit target 200 pips away. If their broker charges five pips per transaction, their ratio will be:
(100 + 5) : (200 – 5)
That yields a ratio of 1:1.85, which is much closer to the 1:2 ratio at face value, regardless of the higher spread.
Effect of win rate on R/R ratio
Simply calculating your risk to reward ratio does not entail effective risk management. You also need to figure out the win rate you need to maintain to remain profitable in the long run or at least breakeven. The good news is, the R/R ratio and win rate are closely related, so you can easily obtain one if you have the other.
If you know your strategy’s ideal risk to reward ratio, you can calculate your minimum win rate using the formula:
Win rate = 1/(1 + R/R ratio)
For instance, with a 1:2 risk to reward ratio, your minimum win rate becomes 1/(1 + 2) = 0.33.
This means you’ll have to win at least 33% of your trades to break even.
Similarly, if you have the win rate of your strategy, perhaps obtained from extensive backtesting, you can obtain the ideal R/R ratio by the formula:
Minimum R/R ratio = (1/win rate) – 1.
For example, if your win rate was 40%, then the minimum risk to reward ratio you can employ is:
(1/0.4) – 1 = 1.5.
Thus, to remain in profit, you need to embrace a ratio of 1:1.5 for each of your trades.
Another rule of thumb is to never risk more than 1% of your current account balance on a single trade. This is so as to ensure that if you make a series of losses, and they will not be enough to blow your account without giving you a chance to recover.
Conclusion
Calculating the appropriate risk to reward ratio is a vital part of risk management. This ratio goes hand in hand with the win rate, as it can help calculate the minimum win rate required to keep you profitable in the long run. Similarly, with a strategy’s win rate, you can easily obtain the appropriate R/R ratio. For best results, you should never risk more than 1% of your equity on a single trade.
