Understanding Risk To Reward Ratio in a Trade

Many new traders think that a good entry into the markets is the key to success. Unfortunately, most are wrong. A trader must view each trade as a business transaction.  A risk to reward ratio compares the potential for reward with the potential for loss. Risk is calculated by counting the pips between the forecasted entry price and the forecasted price at which you want to exit the market in case of a losing trade.

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To manage risk properly, you need to look for high probability trades that have a risk to reward ratio of 1:2 or greater. This depends on the time frame that you want to trade. For example, if you are a day trader and you are looking for making only 30 pips in a trade, a stop loss of 15 pips is sufficient for the risk to reward ratio of 1:2.

The reason that you need to set a higher stop loss is that on a larger time frame, small trends occur within the larger trend. Retracements on shorter time frame is much smaller as compared on the larger time frame. Your trade is going to be recycled. In order to be not stopped out, you need to calculate your risk to reward ratio appropriately.

Consider different risk to reward ratios. How much you need to win to break even for each ratio? For a 2:1 risk to reward ratio, you need 67% winners to become profitable. For a 1:1 risk to reward ratio, it means just 50% winners to become profitable. 1:2 ratio means only 33.5% winners for profitability. Never ever trade when the risk to reward ratio is more than 1:2.