The forex risk-reward ratio represents the calculation of the amount of capital you are willing to risk in your trade versus the amount of capital you plan to gain as your profit.
For instance, traders set the stop loss at five pips and set the profit target at 20 pips. Then, the risk-reward ratio for that traders is 5:20 or 1:4. That trader risk five pips in order to gain 20 pips.
Ways to Use a Risk-Reward Ratio in Forex Market
The theory underlying risk-reward ratio strategy is to get the opportunities getting the highest profit while risking a small capital. The bigger rewards you plan to get, then the more failed trades that your account may encounter at a time.
With the same example, we used above, imagine that the trader makes a successful trade, then he gets buffered from four losing trades with the exact same ratio. If those traders use the same 5:20 ratio consistently, he or she can lose half of the trades, while keep making a decent profit.
Commonly, the risk-reward ratio can give a big help when the market price is near the essential support or resistance. For instance, there is a downtrend for EUR/USD pair and its price has stalled near resistance, while still can post a lower high.
During that situation, the risk and reward ratio will favor a sell trade which uses a smaller stop loss just above the entry.
Types of Risk Reward Ratio That a Trader Can Use
The type of risk-reward ratio that a trader should use highly rely on the type of trader he or she is as well as the market condition. Ideally, traders have to trade with low risk to get high rewards, yet you may find a different case in reality.
There are times when traders have a bigger risk than his or her rewards. Yet, that situation is norma during the volatile market.
Thus, traders have the full authority to choose which risk-reward ratio that they will use. Just remember to always avoid having a bigger risk than rewards.