FOREX TRADING- The Basics Explained in Simple Terms ( PDFDrive.com )

Chapter 5
Further Information on Forex Specifics
Risk-Reward Ratio
The risk: reward ratio is something that you may hear a fair bit about. Some will
say that you should never trade with a risk:reward ratio of less than 1:1, or 1:2, or
1:3 etc. All it is doing is comparing your risk to your reward. Here is an example to
make it very easy to understand.
If we had a risk:reward of 1:2, then for every one unit we are risking, we would be
looking for two units in return. Or to put it in trading jargon, if we had a trade on
with a 30 pip stop, we would be looking for a profit of at least 60 pips to give us our
1:2 risk:reward. If it was a risk:reward of 1:3, then we would be looking for a 90 pip
profit on the same example.
Now why is risk:reward important? Well it is and it isn't. It all depends on your
trading success rate.
If you had a trading system, where you had a fixed 20 pip stop and a fixed 40 pip
profit target on all trades, then your risk:reward is 1:2. If you were successful on
40% of your trades, then in the long run you would be a profitable trader. So that is
not a problem. But if your success rate dropped below 35%, then you would start to
have problems long term.
Where a trader may have a trading method where they use a 20 pip stop and a 10 pip
target on all trades, which gives you a negative risk:reward of 2:1, which in a lot of
traders opinion would be considered a surefire way to ruin. But if that same method
had a success rate of 70%, then this trader would be profitable overall. And there are
plenty of successful traders that trade like this.
To take this further, a trader may have a method where they have a 20 pip stop and a
100 pip target on all trades. Great risk:reward at 1:5. Here, they would only need a
success rate of just under 20% to be a profitable trader. Whether you could stand the
high number of losers is another issue.
Don't be scared off by what others say about risk:reward. There is nothing set in
stone here, but just make sure you have a fair idea of the success rate of your
trading method, so you can see where you should end up over the longer term if
things were to remain constant. If you are losing long term, then something has to
be changed.