How To Calculate Risk Reward Ratio In Forex?

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Trading is exciting, and it has the potential to take people from rags to riches. And undeniably, the idea of raking in big bucks by buying and selling currencies makes trading irresistible. But there’s more to it than meets the eye. While trading is lucrative, it’s also highly risky. One of the most crucial factors that determine whether you will win or lose your trading game, in the long run, is the concept of ” risk and reward.”

Let’s find out what it is and how you can calculate the R:R ratio to ensure consistent profits over time.

What is the Risk to Reward ratio?

This ratio is what helps traders determine the risk they are taking in a position and the return they can expect from it. This ratio is evaluated based on your entry and exit points. It tells you how much profit you can expect for every dollar you risk. If you clearly understand your monetary gain or loss, then you can also determine the pip value of your trades. Let’s take an example: if your risk-reward ratio is 1:5, it means that you are fine with risking a dollar, as you expect to make $5 in return. 

Let’s consider some examples:

Good Risk-Reward Ratio: Imagine a trader who decides to enter a trade with the R:R ratio of 1:2. He places a stop-loss order, which limits their potential loss, 30 pips below the entry price. Additionally, he set a take-profit order, which represents their desired profit, 60 pips above the price at which you entered the position. If the trade moves in the right direction, the trader will earn double the amountthat was put on risk.

In this case, even after some losing trades, the trader have the potential to be profitable in the end because their potential rewards are more than their potential risks. 

Bad Risk-Reward Ratio: Suppose a trader decides to enter a position with a risk-reward ratio of 3:1. He places a SL order 80 pips below the entry price, while their take-profit order is set at only 40 pips above the entry price.

In this case, the trader is risking three times the amount they stand to gain. If the trade goes against them, they will experience a loss that is three times larger than their potential profit. Consequently, they would need a higher success rate in their trades to offset the limited rewards compared to the risks involved.

What’s The Simplest Way To Calculate Risk-Reward Ratio?

There is a simple process of calculating this ratio. You just need to look at the difference between your entry point (where you entered the trade) and your stop-loss level (the price you’re willing to exit if the trade goes against you). This difference represents the risk. Then, you look at the difference between the point of your entering a trade and the target you want to exit the same trade at (the price level where you want to take your profit). This difference represents the potential reward. With the help of a profit calculator, you can also determine the potential reward in your own currency. 

Risk-reward ratio formula

Here’s the formula you can use::

Risk-Reward Ratio = (Entry Price – Stop-loss Price) / (Entry Price – Profit Target Price)

Let’s say you have a trade where the risk is 100 USD, and the target expected is 300 USD. In this case, the R:R ratio is going to be 1:3 because the potential reward is three times bigger than the risk.

To calculate the risk: reward ratio, you’ll have to divide the difference between entry and SL prices by the difference between entry and target prices. 

It’s important to note that the risk-to-reward ratio can vary for each trade setup. However, as a general guideline, if the ratio is higher than 1, it means the potential risk is higher than the reward. In other words, you stand to lose more than you could gain. On the other hand, if the ratio is less than 1, it means the potential profit is higher than the potential loss. This suggests that the potential reward outweighs the potential risk.

Steps to Calculate the Risk-reward Ratio

Step 1: Find the entry price – This is the price at which you enter a trade based on your trading strategy. The entry price sets the starting point for your trade.

Step 2: Identify the stop loss price – It is the price level at which you decide to exit the trade if the market moves against you. 

Step 3: Find your target price – This is the price level where you aim to make a profit and close the trade. 

Step 4: Calculate the difference between the entry price and the price where you have placed your stop loss. 

Step 5: Find the difference between the price at which you enter the trade and the target price.

Step 6: Lastly, you need to divide the difference between entry & stop-loss prices by the difference between entry and target prices. 

Risk-reward Calculator

A risk-reward calculator is among the most popular trading tools that traders use to assess the R:R ratio of their trades. It provides a convenient way to calculate and analyse a trade’s potential risk and reward before entering it.

The risk-reward calculator typically requires the input of the entry price, stop loss price, and target price. Once you enter these values, the calculator will automatically compute your risk-reward ratio.

By using a risk-reward calculator, traders can compare different trade setups and adjust their parameters to achieve a more favourable risk-reward ratio. 

Risk Reward Ratio Myth

You’ve probably heard people saying “high-risk, high reward” all the time. It’s a common belief that you’ll get big rewards if you take big risks. This applies not just to forex but other types of businesses as well. Many traders aim for such trades where risk is low but potential for making huge profits is high. The only drawback of this method is that it often leads to a low win rate. Psychologically, it can be daunting for traders. You see, the risk-reward ratio is just one piece of the puzzle. It’s not the sole determinant of success. Even if you’re constantly seeking trades with a R:R ratio of 1:2, you might end up losing more often than winning.

How To Be Profitable Using Risk-Reward Ratio?

First, divide the position size of your successful trades by the size of the trades you lost. Add one to the result. Then, multiply the value received by your win rate and subtract one. This magical calculation will give you “expectancy,” a key indicator of your trading success.

Let’s take an example where you’ve conducted ten trades; out of those, seven were winners. The remaining three trades ended up as losers. So, your winning percentage is seventy per cent, or simply seven out of ten trades were winners. Let’s say those seven winning trades brought you a twenty eight thousand-dollar profit. If we divide that profit by the number of winning trades, we get an average win of four hundred dollars. 

The idea here is to look at your winning rate, the size of your wins, and the size of your losses. By analysing these factors together, you can determine whether your trading strategy is profitable in the long run. It’s not just about the risk-reward ratio alone. Your expectancy takes into account how often you win, the amount you win on average, and the amount you lose on average.

Verdict

Position risk is all about the possibility of facing losses when you hold onto a specific position. On the other hand, position reward is the potential profit that you can expect from your trades. As such, risk: reward ratio is for creating a balance between the risks and rewards. This allows you to control the risks and the amount you stand to lose if things go south, enabling you to increase your chances of making profits.