The Importance of Understanding Risk to Reward Ratio in Trading

Trading in financial markets always involves some level of risk, and the goal of every trader is to make profits while minimizing their risk exposure. One of the key concepts that traders need to understand is the risk to reward ratio. In this article, we will discuss what risk to reward ratio is, why it’s important, how to calculate it, and some practical examples.

What is Risk to Reward Ratio?

Risk to reward ratio is a measurement of the potential profit compared to the potential loss in a trade. It is the relationship between the amount of risk taken in a trade (the stop loss) and the potential profit that can be made (the take profit).

A good risk to reward ratio means that the potential profit on a trade is at least equal to or greater than the potential loss. This means that even if a trader has a lower percentage of winning trades, they can still make profits as long as their winners are larger than their losers.

Why is Risk to Reward Ratio Important?

The risk to reward ratio is important because it helps traders manage their risk effectively. By knowing the potential profit and loss in a trade, traders can calculate their risk and adjust their position sizes accordingly. A good risk to reward ratio can also help traders stay disciplined and avoid emotional trading decisions.

How to Calculate Risk to Reward Ratio

The risk to reward ratio is calculated by dividing the potential profit by the potential loss. The formula for calculating the risk to reward ratio is:
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Risk to Reward Ratio = Potential Profit / Potential Loss


For example, if a trader enters a long position on EUR/USD at 1.2000 with a stop loss at 1.1950 and a take profit at 1.2100, the potential profit is 100 pips (1.2100 – 1.2000), and the potential loss is 50 pips (1.2000 – 1.1950). The risk to reward ratio in this case is:

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Risk to Reward Ratio = 100 / 50 = 2:1


This means that the potential profit is twice as large as the potential loss.

Practical Examples

Let’s consider two scenarios to illustrate the importance of risk to reward ratio in trading.

Scenario 1: Poor Risk to Reward Ratio

A trader enters a long position on GBP/USD at 1.4000 with a stop loss at 1.3970 and a take profit at 1.4100. The potential profit is 100 pips (1.4100 – 1.4000), and the potential loss is 30 pips (1.4000 – 1.3970). The risk to reward ratio in this case is:

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Risk to Reward Ratio = 100 / 30 = 3.33:1


This may seem like a good risk to reward ratio at first glance, but it’s important to consider the probability of the trade being successful. If the trader’s analysis shows that there is only a 30% chance of the trade being successful, the expected value of the trade is:

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Expected Value = (0.3 x 100) - (0.7 x 30) = 9


This means that the expected value of the trade is positive, but only barely. In this scenario, if the trader is wrong and the trade hits the stop loss, they will lose 30 pips, which is a significant amount of their account balance.

Scenario 2: Good Risk to Reward Ratio

A trader enters a long position on USD/JPY at 110.00 with a stop loss at 109.50 and a take profit at 111.50. In this case, the risk is 50 pips (110.00 – 109.50) and the reward is 150 pips (111.50 – 110.00). The risk to reward ratio is 1:3, which is considered a good risk to reward ratio.

Conclusion

In summary, the risk to reward ratio is an essential concept for traders to understand when managing their risk and reward. It is the ratio of potential loss to potential gain in a trade and can help traders determine if a trade is worth taking or not. While there is no perfect risk to reward ratio, it is generally recommended to aim for a ratio of at least 1:2 or higher to ensure a positive expectancy in the long run.

Remember, trading is inherently risky, and there is no foolproof method to guarantee profits. However, by using proper risk management techniques such as the risk to reward ratio, traders can increase their chances of success and limit their losses.