How to find the best Risk and reward ratio in FX

The Forex risk reward ratio is a metric that traders use to calculate how much they are risking in the market for how large of a reward. Usually, traders would set risk reward ratios of 1:3, 1:2, or anything along those lines.
 
Let’s say that you are trading with $10 and putting it all in one trade. Your risk, in this case, is $10, so let’s give it a coefficient of 1. If you are planning or desire to get a payout of $30 from your trade, that means that your reward ratio coefficient is 3, because 30/10 is 3.
 
However, the risk reward ratio on its own does not really provide any information to the trader unless paired up with another metric, the payout rate.
 
Once the Forex risk reward ratio has been paired up with the payout rate, it is much easier to calculate whether your strategy is going to be successful in the long run. The formula for calculating the risk reward ratio with the payout rate looks like this:
 
P = (1+(X/Y)) x Z - 1
 
We will get to what each of these symbols means and what the formula is able to do for you in the long run in the following paragraphs. You will also learn where and how the risk reward ratio is appropriate or whether you should have it at all.

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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.
Forex risk reward ratio
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.
 Risk reward ratio trading
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.
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Risk reward ratio forex - Key takeaways

The risk reward ratio is a good metric to have but it needs to be personalized according to trading history, strategy, and overall performance of different traders. For example, if your trading strategy yields a negative success rate it may be better to change the strategy and focus on a much smaller risk reward ratio just to balance things out as you carry on experimenting.
 
The risk reward ratio can be directly applied thanks to unique order placements that financial markets provide. These orders are called stop orders or “stop loss” and “take profit”. In order to translate your risk reward ratio trading strategy in actual trades, you will have to do the following.
Let’s say your ratio is 1:3. The “1” here is what you are willing to lose and the “3” is what you want to gain. So, if you are looking for a payout of 15%, you should be ready to risk at least 5%. This scales according to your ratio so it can be easily personalized.
 
The risk reward ratio is not a stable metric because the market always changes and the trader needs to change with it. Keeping one strategy because it had a good payout rate does not mean it will last forever.
Furthermore, the ratio needs to be supported by extensive technical analysis on the background, because just having the ratio does not mean that the trade will always work.


FAQ on risk reward ratios

What’s the best risk reward ratio in Forex trading?

There is no such thing as the best risk reward ratio. All of it is unique according to the trader, asset, instrument, and market trend itself. In some cases a 1:0.25 risk to reward ratio could be the best while others could justify 1:5 or 1:10 even.
In most cases, the risk reward ratio will derive from your analysis of how much payout you can generate from a single trade.


How long does each strategy last per ratio?

Markets change all the time, so a specific strategy can last a day, a week, a month, or even a year. There is never something that is absolutely 100% guaranteed, which is why FX trading is extremely risky. Any high risk reward ratio Forex strategy will fail at some point regardless of how successful it was in the past. Sadly, there are very few ways to predict this, which is why professional traders suggest keeping the risk as low as possible.


Should I calculate my ratio before or after trading for a while?

It is recommended that you have at least a little bit of trading experience before choosing your go-to risk reward Forex ratio. The experience helps you look at your background, calculate your strategy success rate, and then deduce just how much you have risked and gained in total. Creating a ratio from that should be quite easy, giving you a more clear picture rather than guessing from the start.


Are there any indicators that help me with the calculation?

Yes, there is a Forex risk reward ratio calculator that you can install on your trading software, but in most cases doing the calculation are easy enough to do manually. But when the numbers start getting a little bit too complicated you can always use the indicator that is available on the trading software developer’s marketplace.

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