This review is dedicated to reasons why Forex market requires so much attention to the ratio of profit to risk when trading on your own. The lower risk-to-profit ratio can increase any trader’s profitability at the end of the day. That conclusion comes from simple calculations based on elementary mathematics. We will have a look at several factors influencing profitability compared to the risk imposed during trading decisions, as well as examples of how to manage the risk reward ratio, balancing the trading process.
Why is the reward to risk ratio so important in Forex?
The main secret of trading on any exchange is related to stable and continuous result, which depends on the risk reward ratio. The correlation of two parameters is obvious, especially when it comes to the rules of setting stop-loss and take-profit orders. Sometimes it happens that potentially attractive positions must be cancelled due to the higher risks compared to possible profits, despite strong trading signals occurred and all of the other conditions seem to be acceptable. In case if the stop-loss order does not have a desirable depth because of the absence of technical levels to count on, then even lucrative position does not have to be taken by a trader.
Unfortunately, many beginners ignore that requirements, breaking the rule of profit/risk ratio too often. That traditionally leads to unjustified risks related to many entries which do not have the acceptable depth to withstand, even if the potential profit looks very likely. SUch a trading approach is fundamentally wrong, as you cannot take all of the profits in the market, as well as you cannot have 100% correct predictions, so traders must include possible losses in their plans. Any profit has to be balanced with the risk related to the deal opening. This is why the ratio which calculates profit volume to risks is even more important than the number of profitable deals compared to losses. Several conclusions below prove that suggestion.
The base of profitable trading is in the higher profit-to-loss ratio
Potential likelihood of blowing the account balance up depending on different calculations of profit-to-loss ratio:
The first row in the table shows the percentage of profitable deals in the overall number of positions opened in a certain period of time. The first column in the image above indicates several approaches in the profit-to-loss ratio. The lowest row points to the deeper take-profit orders volume, tightening the stop-loss distance further. As the last column of the table shows, 60% of profitable deals has only 12% of probability to waste all of the account balance with 1:1 profit/loss ratio. And it does not include any chances to blow up the trading account with a higher ratio. That means traders should use one of the most important rules in the Forex market: lower stop-loss orders with deeper take-profit depth. Even a decent change of the ratio can save your account at the end of the month.
Of a trader has more than 60% of profitable deals (the overall number) and the profit-to-risk ratio is 1.5:1 or higher, than the trading account, is not imposed to the risk of total loss. That also underlines the importance of the risk-loss ratio to be as higher as possible. The number of profitable deals is not so important as the ratio calculation.
The main Forex rule sounds like this: Cut your losses and let your profits grow!
Let’s have a look at how the data from table works on several examples.
Example 1. Risks and profits are equal, the ratio is 1:1
Having the profit/loss ratio of 1:1 and 50% profitable deals in the Forex market, a trader would have a non-risk trading mode. Opening 100 deals with take-profit and stop-loss orders equal to 100 pips, and having the result of 50% profitable deals during a certain period of time, a trader would get a profit of 0 pips. Meaning that all of the profit received from successful positions will be covered by losses. An obvious question is raised in this case: why should you waste your time for trading which does not bring profits?
Example 2. Reward/risk ratio is 1:2
In case if a trader has a strategy which suggests potential profits two times higher than potential losses, even 50% profitable deals will get a sustainable and continuous profit in Forex trading. For instance, 100 deals were opened with take-profit orders at the level of 200 pips and stop loss-orders equal to 100 pips distance from the entry price. Such a correlation gives a stable profit even with 50% profitable deals, taking the count on a whole half of losing positions. The calculation of the general profit will look like this:
Profit: 50 deals with 200 pips take-profit level gives the total profit of 10000 pips. Loss: 50 positions with 100 pips stop-loss depth suggests a loss of 5000 pips. The total difference is calculated by a simple formula: profit 10000 - loss 5000 = total result of 5000 pips.
This example shows the importance of the risk reward ratio in Forex trading, overwhelming even the total number of profitable deals. Traders must enlarge the difference between potential profits compared to the risks imposed, ignoring trading signals with too deep stop-loss orders and small take-profit levels.