The Proper Risk Reward Ratio in Forex Trading, Explained in Very Simple Words: Make Sure Not to Trade before Reading This
It is very easy to find hundreds of articles on risk/reward ratio in forex trading.
But the problem is that most of those articles are not written by the real and professional traders.
By &8220;real and professional traders&8221;, I mean those who are consistently profitable currency traders and currency market investors.
Most of these articles are written by freelance writers who are paid to write articles.
Or maybe they are bloggers and webmasters who want to drive some traffic to their blogs and sites.
Most of these writers have never placed any order on the market throughout their lives.
The bigger problem is that novice traders believe each and every word of these articles, just because they are published on the Internet.
They don&8217;t know that the directions that these articles give, are not applicable in live trading at all.
After reading these articles, novice traders try to apply them in their trades.
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And, after such a long time of trial and error, they will think that they are not able to follow the trading rules.
So they give up.
But the problem was somewhere else: It is the information and directions of the articles that could not be applied in live trading.
For example, in most of the articles you read about risk/reward ratio, it is strongly recommended that novice traders should not even think about taking positions with a risk/ratio of as high as 1:1 or even 1:2 (I will explain what these numbers mean later in this article), and the minimum risk/reward ratio of the positions that new traders take should be 1:3.
There is nothing wrong with it so far.
But the problem is that these articles never clarify whether traders should have a low risk/reward ratio through having wide targets, OR, by having tighter stop losses.
As nobody likes to lose, specially new traders, they all think that they should make their stop loss as tight as possible to have a low risk/reward ratio trade, whereas this is a big mistake.
No matter how tight or wide the targets are, a trader cannot fool around with the stop loss.
Choosing the stop loss has its own rules that cannot be ignored and broken.
If you set your stop loss tighter than what it has to be, you will be stopped out easily even when your position is correct.
Something that looks even stranger in these articles is that they emphasize that &8220;novice traders&8221; should not take positions with 1:1 or 1:2 risk/reward ratios.
Does it mean that experienced traders can do it?
Are there different trading rules and techniques for novice and experienced traders?
The Same Rules for Everybody
Maximizing the profit and having 1:3 or 1:5 trades can be done by professional and experienced traders.
However, there are some technical and emotional difficulties in front of the novice traders to do that.
For example, to achieve a successful 1:5 trade, you may have several losing trades (I will tell you why), unless you know how to choose the strong trade setups.
This is not a problem for professional traders at all.
But for a novice trader who is learning the techniques and has to build his/her confidence at the same time, having losing trades can cause lack of confidence and excessive fear that prevents him/her from advancing to the next steps.
So we cannot believe and apply whatever we read over the Internet.
There are zillions of systems, techniques, indicators, robots and&8230; that are absolutely useless when it comes to live and real trading.
What Is Risk/Reward Ratio?
After the above introduction, let&8217;s see what risk/reward ratio is and why it is important in forex trading.
Risk is the amount of the money that you may lose in a trade.
If you&8217;ve already read the money management article, you know that we should not risk more than 2-3% of our capital in each trade.
It means when we find a trade setup and we find a proper place for the stop loss, we have to choose our position lot size in the way that if the market hits our stop loss, we lose maximum 2-3% of our capital.
For example, let&8217;s say we have found a trade setup with EUR/USD that has to have an 80 pips stop loss.
The account size is $5000.
If EUR/USD hits the stop loss, we should lose $150 which is 3% of our capital:
0.03 x $5000 = $150
It means 80 pips equals $150 (you can use the position size calculator I have on the money management article).
This $150 is our risk.
But what is the reward?
Reward is the profit that we can make in a trade.
In the above example, if we choose a 160 pips target for our trade and EUR/USD hits this target, we will make $300 (when 80 pips equals $150, so 160 pips equals $300).
This $300 profit is the reward.
So what is the risk/reward ratio of this trade?
It is 1:2 because:
150:300 = 1:2
The larger the profit (target) against the loss (stop loss), the smaller the risk/reward ratio which means your risk is smaller than your reward.
For example, if your stop loss is 20 pips in a trade and your target is 100 pips, your risk/reward ratio will be 1:5.
What Is the Recommended Risk/Reward Ratio in Forex Trading?
1:3 or 1:5 risk/reward ratio is achievable when (1) the market trends after forming a strong trade setup, and (2) you succeed to enter on time.
In most cases you should be able to hit the top and bottom of the trends, no matter on what time frame you trade.
Or if you enter at the middle of the way, the trend should be strong enough to give you another big movement and make a profit which is 3 or 5 times bigger than your stop loss.
You can do that.
But there are just a few problems:
1. Markets usually trend only less than 30% of the time.
2. Some trends are not strong enough that if you enter with delay and while the trend is at the middle of the way, they can hit a target that is 3 or 5 times bigger than the stop loss.
3. There are many cases that you miss the trends.
You hesitate to enter, and so you miss the chance.
Or, you think you have found a trend whereas you are wrong and it returns and hits your stop loss, and things like that.
So you lose in many trades, because you want to catch a big one.
Therefore, in reality, you either have to lose in many trades, or, you have to have many of your trades closed at breakeven by the stop loss (because you will have to move the stop loss to breakeven when you are in a special amount of profit), or, you have to stop trading for such a long time and wait for a strong trend, until you can have a 1:3 or 1:5 trade.
Is It Possible to Catch the 1:3 or 1:5 Trades?
How is it possible to catch a 1:3 or 1:5 trade without losing so many trades or waiting for so long?
If you take a position with 1:3 or 1:5 stop loss to target ratio, and then you wait for it to hit your stop loss or target, you will have so many losing trades before having a winning trade.
The reasons are mentioned above.
1. Moving the Stop Loss Further
One solution is in moving the stop loss.
You should not let your stop loss remain at its initial position.
To have a 1:3 trade, the distance of your entry and your final target should be split into 3 parts (at least), while each part is equal to your original stop loss value.
For example, if you have a 50 pips stop loss, you should have a final target of 150 pips that should be split into three 50 pips levels.
Then you should move your stop loss in three stages.
In this example I assume that you take a 3% risk in each trade:
1. If the price reaches the first 1/3 level, you should move the stop loss to breakeven.
At this stage, if the price goes against you and hits the stop loss, you will get out without any profit/loss, BUT you should consider that you had an initial risk of 3%.
2. If it reaches the 2/3 level, you should move the stop loss to 1/3 level.
At this stage, if the price goes against you and hits the stop loss, you will get out with a profit that equals your initial risk.
For example, if your stop loss has been 3% of your account, you will get out with a 3% profit.
Therefore, such a trade will be ended as a 1:1 risk/reward position.
3. If it becomes so close to the final target, you should move the stop loss to 2/3 level.
&8211; Hitting the Final Target:
Then you have to wait until it hits the final target or returns and hits the stop loss.
At this stage, if it goes against you and hits the stop loss, you will get out with a profit which is twice of your initial risk.
For example, if your stop loss is 3% of your account, you will get out with a 6% profit.
Therefore, such a trade will end as a 1:2 risk/reward position.
If the price hits the final target, your trade will close with a 9% profit.
Therefore, you will have a 1:3 risk/reward position.
So, to have a 1:3 trade, you will have some -3% trades that are those positions that hit the stop loss at its initial position.
You will also have some 0% trades that are those trades that hit the stop loss at breakeven.
Some of your trades will be +3% trades that are the ones that hit the stop loss at 1/3 level.
Some will be +6% trades that are the ones that hit the stop loss at 2/3 level.
And finally, some trades will be +9% trades that are the ones that trigger the final target.
2. Taking the Too Strong Trade Setups
Another solution is in taking the too strong trade setups on the long time-frames like daily, weekly and monthly.
Wait for the too strong trade setups.
They are usually strong enough to move the price for hundreds of pips, and so you can have wide targets.
How Many of Your Trades Will Be -3%, 0%, +3%, +6% and 9% Trades?
It is impossible to answer the above question.
It depends on many factors, including the trading strategy and the markets condition.
However, there is something that gives us a clue about the number of our 1:3 and 1:5 trades.
It is the fact that says market trends only 30% of the time.
It goes sideways 70% of the time.
To have 1:3 and 1:5 trades, we should have a strong trend, otherwise the price hits our stop loss.
It stops your position before reaching the final target, no matter what time-frame you use to take your position.
No need to remind again that in any of the -3%, 0%, +3%, +6% and 9% trades, your risk is the same which is 3%.
The first conclusion is that taking the risk and the position is up to you.
However, it is the market that determines how your trades will end.
This is something that all traders, specially the novice ones, should consider.
When you read in different websites and web pages that you should take the 1:3 and 1:5 trades only, then you should consider that you really never know how many of your trades will end as 1:3 and 1:5 trades.
Never Break Any of Your Rules
I set the stop loss of my positions based on the technical analysis rules.
I will never break any of these rules.
Some traders think that my stop losses are too wide, but they are not.
Some traders always have a fixed stop loss size.
For example, any positions they take, with any currency pair and any time-frame, has a 120 pips stop loss.
But, I mainly follow the rule of thumb we have for setting of the stop loss.
The rule says that you should place your stop loss in a position that it becomes triggered only when the direction you&8217;ve chosen is completely wrong.
So, when I want to set the stop loss, I ask myself under what condition the position I have taken will be wrong?
The answer I give to this question is the position of the stop loss.
Are you new to forex trading?
Then learn how to take the strongest trade setups on the longer time-frames.
Read these article carefully to save a lot of time and money and become a profitable trader sooner:
- Monthly Time Frame Is the King
- Trading Strategies Don’t Work If You Don’t Choose the Right Living Strategy
- Make Your First $100,000 Trading Forex
Proper Risk Management in Forex Trading
You can sit at your laptop, trade forex and make a lot of money from the comfort of your home. This is too exciting and attractive to everybody. It looks like a very easy business at the beginning. You start reading about forex and soon you will realize that forex really makes money.
First, we are eager to find something that makes money. When we succeed to find it, we think about the ways that make more money with it. You ask yourself whether it is possible to make more money within a shorter time.
Human is infinite by nature. We don&8217;t want to be limited at all. We want to be free to do anything we want. When it comes to forex trading and we see that it can potentially make money, we want to maximize the money it makes. One of the ways that comes to our mind to make more profit within a short time, is taking a bigger risk. This is a way that comes to the most of the novice traders&8217; minds, specially because many of them can not open a live account with a reasonable size. However, it is a risky way. I will tell you why. There is a much better way to grow your account faster. Before talking about that way, please see the below examples to see how taking a high risk can &8220;theoretically&8221; grow your account much faster, but can practically wipe out your account.
If you open a $1000 account and make 5% profit per month, your account balance will be $3,225.10 after 2 years, if you don&8217;t withdraw any money and keep on making 5% profit every month for 2 years.
If you keep on trading that way, your account balance will be $18,679.19 after 5 years.
I don&8217;t say that you can consistently make a 5% profit for 5 years. You will have some losing months as well. These numbers are just examples.
If you can neither make more profit, nor you can open a larger account, you have to be happy with the rate that your account is growing, or you have to find a different way to grow your account faster which can be more riskier as well.
If you open a $50,000 account, and make the same 5% profit per month, your account size will be $161,255.00 after two years (of course if you don&8217;t withdraw any money for 2 years). Then you can keep on making 5% profit per month, and withdraw $8,062.75 every month. That is not bad. Indeed, it is a good monthly income. But the problem is, most of you cannot open a $50,000 account at the beginning.
So the only option that comes to your mind, is taking a higher risk. That is when the greed takes the control and you can lose your shirt because of it: You think you open a $1000 account with a 500:1 leverage. You can take a 1 to 2 lots positions with such an account without any problems. Then you calculate and will see that if you open a $1000 account and make 100% profit per month (you double your account every month), you will have $4,096,000.00 after one year or $16,777,216,000.00 after two years (of course if you don&8217;t withdraw any money).
Wow! It is amazing. It is mind blowing, isn&8217;t it?
You can become multi-millionaire within 1 to 2 years, by risking only $1000.
Having such a big amount of money in the trading account you have with a broker, is possible only on the paper, not in reality. Read these articles:
- Trading Strategies Don’t Work If You Don’t Choose the Right Living Strategy
- Some Forex Trading Facts and Myths You Must Know
The other thing is that it is impossible to make a 100% profit every month for several months or a few years while your account leverage is 500:1 and you are risking too much. Those who try to double their accounts every month, can get lucky to do it once or twice, but then they will wipe out their accounts the next month. To double your account within a short time, you have to take too much risk that will result in big losses finally. If it was that easy, now we had so many millionaires in the world who would do nothing but trading Forex from the comfort of their homes.
The problem is 99.99% of the traders decide to turn a small amount of capital to a huge wealth, while they have not properly learned to trade yet, and they have not passed all of the learning stages. They open an account and try to double it every month after a few weeks/months of learning and practicing. Therefore, they lose their money and blow up their accounts.
Many of these traders top up their accounts a few times, but the same thing happens over and over again. Why? Because they don&8217;t know how to trade. They want to double their accounts every month through Forex trading, but they don&8217;t know how to trade Forex properly. So&8230; A sweat dream changes to a nightmare, and someone who wanted to become a multi millionaire within 1 to 2 years, gives up on Forex trading after losing several thousands of dollars.
You should complete the learning stages first, open a live account, take a reasonable risk in each trade, manage your risk, position and profit, and grow your account slowly and steadily.
1. We have already talked about completing the learning stages a lot. You can follow the below posts carefully and you will pass the learning stages easily and without any headache: Become A Profitable Forex Trader In 5 Easy Steps
2. Now, I assume that you have passed all the stages and you have repeated your success with your live account at least for 3 months consecutively. Above all, I assume that now you are patient and disciplined enough to wait for the strong and perfect trade setups. So your success rate is really high. I mean you pick the trade setups that either hit the targets, or at least give you the chance to move your stop loss to breakeven. So you are now ready to grow your account.
Start with a small account at the beginning. Don&8217;t think that if you open a big account, you will shorten your way. Risking a larger amount of money creates harmful emotions that don&8217;t let you trade properly. Your greed pushes you to open a larger account, and then your fear makes you blow up the account.
3. You should trade patiently until you double this account. I don&8217;t know how long does it take you to do it, but be patient until you double your account. Then withdraw the initial capital and leave the profit in your account. You are now trading with your profit, and you are not risking your capital money.
These are the articles you will definitely need to read:
- Double or Even Triple Your Forex Trading Account Risking 2-5% Only
- Forex Calculators
- Risk/Reward Ratio in Forex
- Money Management in Forex