Forex risk reward ratio strategy - how it works
Let us discuss the formula that we have mentioned above. It is a very important metric when we are trying to use the risk reward ratio to our advantage. The symbols that you see in the formula have the following meanings
- P = success rate
- X = the size of average payouts
- Y = the size of average losses
- Z = payout rate
So, with this information, we can easily start to calculate the success rate based on our trading history.
Let us say that we made 10 trades out of which 2 were unsuccessful and 8 managed to bring us some payouts. This means we had a payout rate of 8/10 which means 80%, so 0.8. Although we may think the risk/reward ratio is 1:4 it’s not necessarily the case quite yet.
Imagine that the total payout was $4000, so that would mean our average payout is $500, because of 4000/8 = 500.
In terms of unsuccessful trades, let’s say that our net loss was $2000. That means that the average loss is $1000 because 2000/2 = 1000.
Now let’s apply all of this information to our formula.
P = (1 + 500/1000) x 0.8 - 1
This would bring us a success rate of 0.2 so 20%. The good news is that this is a positive success rate, meaning that the strategy we have been using is feasible.
As long as our Forex risk reward ratio brings us a positive success rate, it is feasible to use it, but you can already see that the ratio in our example wasn’t necessarily what you may have seen.
If we calculate accordingly, the risk reward ratio was 1:0.5, which may not seem like a good idea. But, as you can see, even the lowest of the low risk reward ratios can be successful in the long run.
Where does the risk reward ratio apply?
The risk reward ratio may seem like just a combination of numbers that are based on your trading patterns, but how exactly do you apply this to your trading?
Well, thankfully the risk reward ratio in Forex trading directly translates into the types of orders
you can place in the market.
You may have already heard of stop orders. It is a type of order that helps traders automatically close or “stop” their orders when an asset reaches a specific price point.
The most common types of orders within stop orders are “stop loss” and “take profit”. They mostly do exactly what their names imply. The stop loss order will close your trade once you’ve taken a specific amount of losses, and the take profit order will close your trade once you’ve generated a specific amount in payouts.
Now, why are these order types important with risk reward ratios?
The reason is that every Forex risk reward strategy can be visualized with these order types. Let’s imagine that the exchange rate of the AUD/JPY is 100.00. You gain some valuable information which implies that the pair could potentially increase to 150.00 exchange rate, or decrease to 70.00.
Most traders would open their trades, and start placing the following orders. Take profit at 140.00 exchange rate and stop loss at 80.00 exchange rate. This has mostly to do with the highest or lowest points of predictions that tend to be quite hard to reach.
This type of order placement would put us in a unique position. If we use our Forex risk reward calculator, we will quickly see that the ratio is 1:2. Why? Very simple.
Since the exchange rate is 100 and we would like to get a payout at 140 that means that we are looking for 40 points so to say. However, we are also ready to leave the market at 80 points so we are willing to lose 20 points in total. All we have to do is divide the losing points by the gaining points and we get the risk/reward ratio we have been looking for. In this case that is 1:2.