One of the most important risk management concepts in forex is the risk reward ratio. Particularly when it comes to position sizing, risk reward or risk return ratios – the two terms mean exactly the same thing – are one of the most important tools for trading in a way that is strategic and considered rather than responsive and irrational.
What is the risk reward ratio?
The risk reward ratio shows your potential earnings for every dollar risked in a particular transaction. In other words, it is the ratio of your potential gain to your potential loss. An example: A trader is placing a long AUD / USD trade for $1000 – he has set a stop loss at 50 pips below the current price and a take profit 100 pips above. This trade has a risk reward ratio of 1:2 – the trader stands to lose just half as much as he will gain if the trade is successful. This can also be expressed as the decimal 0.5.
Why do I need to check the risk reward ratio?
When monitoring a trading strategy, you will need a few data points to see whether you are successful: What percentage of your trades are succeeding vs those hitting the stop loss, what the relative position sizes are on those trades, and of course the overall returns. If you find that you have a convincing technical or fundamental strategy, and are getting it right 60 or 70% of the time (this would be exceptional in real life), it is possible to run greater risks and remain profitable.
For the overall portfolio, a strategy that produces winning trades 50% of the time would require a risk reward ratio of 1 to break even (excluding fees). If your trades only succeed 40% of the time, you would lose money with a risk reward ratio of 1 – but not if it was 0.8 or below.
How do you calculate the risk reward ratio?
The calculation of the risk reward ratio is quite simple:
(Trade entry point – stop loss point) / (Take profit point – entry point)
Though the calculation is easy there are other factors to consider. Sometimes different rules conflict: It is normally recommended not to exceed 5% of your overall portfolio in a single trade, no matter the risk reward ratio, but for smaller portfolios, allocations of less than 5% might not be viable without using leverage.
Many traders refuse to enter trades with a risk reward ratio higher than 0.5 – they want more than two pips of winnings for every one pip risked. This is okay for some strategies, but a mistake if you are using a high volume strategy such as scalping. Much better to confirm your expected ‘win rate’ and then use a fitting risk reward ratio.
Some traders, confusingly, prefer to talk about reward risk ratios, and provide backwards quotes. If you find yourself getting confused, check.
Risk reward ratios in technical trading
Traders who believe they have identified a particular price pattern or formation might well use it as the basis for both their take profit and stop losses. For example, if you have just seen a clear head and shoulders pattern in the AUD / USD chart, you might want to set a take profit just below the ‘neckline’ of the completed pattern, and the stop loss back at the top of the second shoulder. That way, if the pattern was illusory or breaks down, the stop loss will be triggered.
This is a good strategy, but be careful to keep an eye on the risk reward ratios when trading in this very visual manner: A high shoulder could result in a very distant stop loss, requiring an ambitiously placed take profit level to be successful. Sometimes it is better, albeit less elegant, to just use a 2 to 1 return to risk position sizing strategy.
Incorporating the ratio in your trading
Ideally, risk reward ratios will become something you think about naturally as you place every trade. Some charting tools give you the option of placing onto the price chart a ‘risk reward bar’ which you can adjust to show the position of a trade for each risk reward level. This can allow you to visualise clearly the kind of price moves required for your trade to be executed successfully.
Novice traders in particular should remember that losses are a natural part of trading. Using the risk reward ratio as part of your strategy gets you used to the idea that you are aiming for a particular ‘success rate’, and that you do not need to be correct every time to have a profitable strategy. Remember that losses are part of your trading plan and not something to be avoided.
Also remember that even if you have back-tested with a success rate of 60% you might have a run of seven or eight stopped out trades; this is normal, the rate will only reach its average over long time scales and it is important to stand by your strategy if this happens.
Points of advice
The following advice is worth keeping in mind, particularly if this is a new concept for you:
- You can start by using a 1:2 (0.5) ratio for all trades; remember not all strategies require this.
- Monitor your ‘hit rate’ on your trades and make sure you are meeting the required level to be profitable (it is the same as the risk reward ratio).
- Once you are comfortable with the concept consider changing positions to see how it affects the ratio and your profitability.
From a risk management perspective, the usual rules about not doubling down on trades or changing stop losses apply. Above all, risk reward ratios are a risk management tool to protect you from embarking on destructive, losing strategies.
Using the ratio to calculate position sizes
It may seem like all this is extremely prescriptive and prevents you from placing positions according to your market views; remember that you can increase or decrease the stop loss and take profit points in tandem, preserving the ratio. This allows you to magnify the absolute size of both risk and reward while leaving the ratio intact.
This practice neatly illustrates one of the dangers of relying on the risk reward ratio alone; a GBP / AUD trade at an initial price of 1.85300 with a take profit at 1.95000 and a stop loss at 1.8045 would have a healthy risk ratio of 0.5; and yet, particularly if you are using leverage, is a risky and expensive trade.
A quick search for ‘forex position size calculator’ will reveal various useful tools giving you exact position sizes and take profit / stop loss points for a specific trade. Always be mindful of the realism of the trade, and don’t forget to look at the usual indicators and charts at the same time.
Specific strategies and the risk reward ratio
Different trading strategies demand different risk reward ratios. Certain strategies, namely trend following ones (sometimes called momentum strategies), rely on being correct a higher proportion of the time and with large risk reward ratios, usually by having a very tight stop loss in case of a sudden reversal.
By contrast reversal strategies, whether they are based on indicators such as the relative strength index or candlestick patterns, normally have lower success rates. Therefore they become profitable only with lower risk reward ratios, normally (but not always) below 1. Since reversals happen less frequently than trend continuation, this is not surprising.
It is not important what strategy you use provided you have a sense of how often you will be correct, through back-testing and your performance history, and set trade levels to match the corresponding risk reward ratio.
How Rakuten can help
Risk reward ratios and success rates can be confusing at first, but will soon become a familiar and useful part of your trading knowledge. To start practicing different strategies, why not sign up for a free demo account and start placing trades without risking any of your capital?