Lesson 36 – Risk vs Reward (RRR), A Guide for Forex Traders
Risk vs reward ratio (RRR), what is it?
Once you start trading and diving into the markets, there is a very good chance that you’ll quickly stumble upon the term “risk-reward ratio”.
This is something that is extremely important to understand if we want our forex trading to be successful.
Basically, the risk-reward ratio is the amount of capital placed at risk for the expected gain that we are targeting in a single trade.
How is RRR calculated?
Before entering any trade, we must first calculate our risk-reward ratio.
To do this, we just need to have: our entry price, stop-loss price, and our target price.
Imagine we want to place a BUY order on a currency pair at an entry price of £100.
We need to first figure out how much we might lose if our trade goes badly. So let’s say we would lose £10 if it goes badly.
Afterward, we should ask ourselves how much profit there is to gain if our trade goes well. So let’s say we would gain £30 if it goes well.
Once we know this, we can see that our risk to reward ratio is 10/30, or 1:3. In this case, we can see that the reward is 3 times the size of our risk exposure.
Instead of using absolute currency amounts, let’s now use pips instead. So, let’s imagine we want to enter a scalping position to make a 20 pip gain and we set our stop-loss order at 10 pips lower than our entry.
In this scenario, our risk-reward ratio would be 10/20, or 1:2.
But how should we interpret this and use it to help us in succeeding with our trades?
Why should we care about risk-reward ratio?
The reason why we care about risk-reward ratio is that it’s crucial in calculating what percentage of trades we would need to win in order to make a trade of that type profitable.
So, let’s see what percentage winning rate we would need to break even with different levels of risk-reward ratios.
IMAGE DETAILING DIFFERENT LEVELS OF RRR AND THE ASSOCIATED WINNING PERCENTAGE LEVELS
Problems that come with a very high RRR
As one can tell from the table above, as we increase are risk-reward ratio, our winning percentage rate required to break even goes down significantly.
Often, novice traders get excited by these low win rates because they think it’s easy to achieve more than the slim percentage rates required if they target large RRR levels.
While there is a logic to the fact that you do only need to win a relatively small percentage of the time to be profitable, there are some issues we need to take into account.
Exposure for a longer period of time
The higher our targeted RRR, the more time we will have to spend with our trading positions open. The more time left open, the more exposure we have to the forces of the market.
The longer we are exposed to the market, due to the stress entailed in trading, the higher the chance that we become too erratic and make poor decisions that aren’t objectively cool.
Dealing with higher number of losses
Since we are targeting a higher RRR, naturally, we will lose out a lot more often than with lower RRR’s. This means you will have to deal with multiple sessions of losses before hitting your wins. This can become very taxing even for veteran traders, on both your mental state and your trading balance.
Taking profits too early
Because of the previous problem of often hitting losses, stressed traders will often start taking their profits early in order, for security, in order to make back some of the earlier losses.
What this actually ends up doing is condemning themselves to unprofitability.
This is because, if you cut your trades short all the time, you won’t reach the high target rewards you were initially intending to achieve.
This means that you won’t be recuperating all the previous losses you’ve made, and your required percentage winning rate will have to increase.
However, succeeding as a trader using a high RRR is achievable, but a lot more difficult and risky. For someone who is new to trading, it’s best to stick to lower RRR levels and adjust later to what you’re good at.
What RRR should one use?
What the correct answer is for this question rests entirely on the type of trader we’re talking about. However, a 1:3 RRR is a very commonly preferred risk to reward ratio used by a lot of traders.
Using a 1:3 RRR allows you to succeed in a good portion of your trades rather than constantly lose out and hope for a big hit.
Since it requires only a 25% success rate in order to break even, it is definitely an achievable target if you are disciplined and use the tools we’ve shown you in this course so far.
Make sure you constantly monitor your trades to see if your trade reasoning and theory have become invalidated or not.
Also, be careful and fully aware when you decide to cut your winning trades short and decide to move your stop-loss orders to entry positions or convert them into trailing stop-loss orders.
The Bottom line with RRR’s
In the end, you should note that the RRR levels you should target and work with are not fixed, and you should use them as a tool to help guide your trades in setting the correct targets and expectations.
Don’t force things.
For example, let’s say you want to set up a specific BUY trade with a RRR target of 1:3 but that currency pair has a clear resistance level that would likely cap it to 1:2 instead. In this case, make sure to adjust your required win rate and expectations accordingly.
Risk to reward ratios are merely possible guiding tools for our trades, not a cornerstone to focus everything around and forget everything else we’ve learned about in this course so far to succeed in trading.
Remember your trading fundamentals we’ve introduced, stay disciplined, and you should be good.