The risk-to-reward ratio is an important concept and fundamental principle that helps guide a trader, especially successful traders. As we all can agree, the forex market could be a challenging and volatile environment hence there is a need for traders to take calculated risks in expectation of reward.
Generally, the risk-to-reward ratio is one of the factors that play a vital role in determining the overall profitability and sustainability of a trader’s portfolio.
Many traders believe that the higher your risk-to-reward, the higher your profitability. However, in this article, we will discuss whether this assertion is true.
The risk-to-reward ratio is the metric that traders and investors use in calculating the potential reward or how much they would gain for the total amount they risk or how much they are willing to lose on that trade. Hence, we can say we can say that the risk-to-reward ratio (R: R) is a numerical representation of the potential profit relative to the potential loss in a trade.
The majority of investors and traders use the risk/reward ratios metric to compare the expected ROI (Return On Investment) of a trade with the amount of risk they must undertake to earn these returns.
For larger investors, a lower risk-to-reward ratio is usually preferable because it shows that the investment is less risky for an equivalent potential gain.
Most traders use this risk-to-reward metric to plan which trades are viable for them to take. The ratio is calculated by dividing the amount a trader is willing to lose if the price of a currency or an asset moves against the anticipated direction- the risk by the amount of profit the trader expects to make when the trade moves in their anticipated direction.
According to Investopedia, market strategists in many cases have found out that the ideal risk-to-reward ratio for their investments is approximately 1:3. This means that for every unit of risk they undertake, the expected return is three units.
In calculating risk-to-reward and managing capital, stop-loss orders are very crucial. They aid easy calculation of the risk to be undertaken and its ratio to the expected return.
This metric is used as a measuring tool by traders when trading currency pairs. However, the best risk-to-reward ratio varies as it depends largely on the trader’s risk tolerance and the strategy used. To determine the favourable risk-to-reward ratio for any given strategy, backtesting and forward testing will be needed.
To calculate the expected return, traders mostly use historical price action, the Fibonacci tool, moving averages and some other tools available at their disposal.
Though investors may use these tools to calculate their expected return, they make use of other models such as estimating the weighted probabilities of future outcomes and the capital asset pricing model (CAPM).
While traders can use conventional technical analysis and price action, Investors use fundamental analysis, financial statements and the Vaule-at-risk model.
Calculating the risk-to-reward ratio is very easy.
The risk-to-reward ratio is calculated by dividing the amount of potential loss by the amount of potential profit. The formula is as follows:
Risk-to-reward ratio= Amount Of Potential RiskAmount of Potential Gain
As simple as it is written above.
When the risk-to-reward ratio of a trader is oddly too high, it could be deemed that the potential gain is extremely high relative to the potential risk. This tells you as a trader that the trade placed or investment made is riskier than it appears. The opposite is true for a less risky trade.
This is why, as has been mentioned above, investors approach the market with low-risk-to-reward tactics.
Consider a scenario whereby a GoatFunded Forex trader aims to profit from the potential upward movement of the EUR/USD currency pair. At the entry point of 1.1500, the trader buys 10,000 Euros, setting a stop-loss order at 1.1400 to limit potential losses and a take-profit order at 1.1700 to secure potential gains. This trade is characterized by a risk/reward ratio calculation, comparing the potential loss to the potential profit.
In this instance, the trader is willing to risk 100 pips for a potential gain of 200 pips, resulting in a risk/reward ratio of 1:2. This implies that, for every pip at risk, the trader anticipates making two pips in profit. Adjustments to the risk/reward ratio can be made by modifying the take-profit order while keeping the stop-loss order constant.
Suppose the trader seeks a more aggressive risk/reward ratio of 1:3, leading to an adjustment of the take-profit order to 1.1600. This modification increases the potential profit to 300 pips, maintaining the same 100-pip potential loss, resulting in a revised risk/reward ratio of 1:3.
While a more aggressive risk/reward ratio may seem appealing, it comes with trade-offs. Adjusting the take-profit order closer to the entry point enhances the likelihood of hitting the target but also increases the risk of triggering the stop-loss order.
As traders you must strike a delicate balance between risk and reward, adapting your risk/reward ratios to align with their risk tolerance, market analysis, and overall trading strategy.
The importance of risk to reward has been discussed throughout this article. However, we will highlight two major importance of Risk-to-reward in forex trading.
The major priority of any trader or investor should be to preserve capital as much as possible. Risk-to-reward not only preserves capital but also helps a trader to scale up their account. This means, that even if a trader’s win rate is low, Risk-To-Reward helps to mitigate the losses incurred.
Let's take, for example, a trader whose win rate is 30% and has a static risk-to-reward of 1:4. This means out of ten trades the trader is expected to win three trades. Now let’s do some calculations assuming the trader risks $100 per trade.
For the winning trades,
Out of 10 trades, the trader successfully wins 3 trades.
Each winning trade results in a profit of $400.
Total Profit from Winning Trades=30 trades×$400=$12,000
For the losing trades,
The remaining 70 trades end up as losses.
Each losing trade incurs a loss of $100.
Total Loss from Losing Trades=70 trades×$100=$7,000
Net Profit=Total Profit from Winning Trades−Total Loss from Losing
Can you see that despite a win rate of only 30%, the trader remains profitable due to the favourable risk-to-reward ratio of 1:4?
That is the power of risk to reward in preserving capital while growing it.
This is another key outcome of a well-considered risk-to-reward ratio. Achieving a balance between winning and losing trades is crucial for consistent profitability. The ratio ensures that winning trades carry sufficient weight to offset potential losses, contributing to the overall resilience and stability of a trader's portfolio as seen in the example above.
In the end, the importance of risk-to-reward cannot be overstretched. It is also very important to note that this ratio is subjective and differs from trader to trader. While higher RR could provide more profit while risking less, it is also crucial to understand that it is more risky.