One of the most important aspects of any Forex trading strategy is risk management. Risk management guides traders when to exit the market. Any experienced Forex trader will tell you that knowing when to exit a trade is even more important than knowing when to enter. When you formulate your Forex trading strategy, you will need to make sure you understand risk management. One of the key factors in risk management is Reward-Risk Ratio.
The reward-risk ratio is the profit you expect to make on a particular trade relative to the amount we are willing to lose if the trade goes badly. This ratio assists Forex traders in making trade decision before entering the trade. The trader needs to know how much he is willing to risk at any given time and for what potential gain. Knowing the expected result before entering a trade can be extremely useful in Forex trading. Of course it is profitable to increase the margin of profit while limiting the potential loss. When you have too large a risk for your reward you can pay a very hefty price.
According to some, the ideal reward to risk ratio is 3:1. Then if you only won half of your trades you would still make a significant profit. If you set your limits to exit a trade at this ratio, you have a very good chance of being profitable. Obviously, different types of traders look for different ratios. A trader who expects to hold on to their positions long term will be aiming for a different ratio than a day trader. The reality is there is no one size fits all reward to risk ratio. Knowing how to watch the market and set your limits will help you determine which ratio is good for you.
Market conditions are also a factor in determining the best ratio to aim for at any particular time. In order to set realistic goals, you need to know what you can expect from the current market. It is not even an absolute rule that your risk should be much smaller than your reward. Occasionally the market is so volatile that the ideal ratio is reversed.
One of the most common mistakes in reward-risk ratio management is looking at the reward first. When you approach reward-risk ratios from the reward side first, your greedy side can get the best of you and cloud your judgment. The other common mistake to avoid is placing your stop loss too close to the entry point to allow the trade to work. If you focus on the risk and then make the reward a multiple of the amount you are risking, you have a much better chance of profit than if you do the opposite and lose sight of the risks involved.
You can draw a chart for the various reward-risk ratios that you are considering and then make a more educated decision. It is wise to make sure you understand how to use these ratios to your benefit before making any Forex trading decisions.