We have already mentioned that all risk management in the Forex market requires a trading system that must be tested to achieve its function: obtain a good return on our foreign exchange trades. One of the practices that, in the long term, can become very convenient is to establish an adequate risk/reward ratio in our trades. Here we will explain the basics of this practice and how to put it into practice.
What is the Risk/Reward ratio?
It is a trading practice through which we will only trade when we know that we have the possibility of obtaining a certain benefit on the amount placed at risk. For example, if we establish in our trading system that we want a risk/reward ratio of 1:3, it means that we will perform those trades that ensure we obtain 3 pips for each pip put at risk.
As simple as that? Everything could indicate that it is that easy, but given that we are neither seers nor fortune-tellers, we will never have the certainty that each trade that we carry out will return a risk/reward of 1:3. Therefore, it is a strategy that takes into account that we can suffer losing trades. It happens that, when we establish this type of relationship, over time we will become successful traders in the Forex market. To see it more clearly, let’s look at the following image:
As we can see, we have made a total of 10 trades and 50% have generated profits while in the other 50% we have had losses. However, as our risk-reward ratio was 1:3, at the end of all trades we obtained a profit of $10,000.
Considerations on the Risk/Reward ratio
Is there a strict rule of what the optimal risk/reward ratio should be? Definitely not. The risk/reward ratio should be flexible and adapt to the trading environment, the data that come from the economy and the timeframe. Also, in that relationship you should consider that your broker will receive a spread that will reduce that ratio. Do not forget to keep it in mind.
Another important aspect to consider when working with a risk-reward ratio strategy is the use of stop losses. Here, the trader must be careful to adjust the level of these stops when the trade is giving benefits.
This is of great importance, since the stop loss would prevent the trade from turning against us when it has been beneficial. It is always important, and it is part of the risk management, to have an emergency exit, in case the trade becomes a loser.