Many new traders think that a good entry into the markets is the key to success. Unfortunately, most are wrong. 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. A trader must view each trade as a business transaction.
Reward is calculated by the pips between the forecasted entry price and the forecasted price at which you would want to exit the market in case of a winning trade. Reward is the expected number of pips that you want to make in a trade that will be a winner.
In order to manage risk, you need to look for high probability trades. Trade only if the risk to reward ratio is 1:2 or higher. Your risk and your reward depend on the time frame that you want to trade. Suppose you are a day trader. You are expecting to make only 30 pips in a trade. For the risk to reward ratio of 1:2, a stop loss of 15 pips is sufficient.
However, if you are a swing trader or a position trader with a longer time frame, your profit potential will be more. If you choose 200 pips as your expected profit then you will need to set your stop loss at 100 pips.
The reason that you need to set a higher stop loss on a larger time frame is that small trends occur within the larger trend. Retracements on shorter time frame are much smaller. Retracement on the larger time frame is much bigger. Due to smaller trends in the larger trends, your trade is going to be recycled. In order to be not stopped out of the trade, you need to calculate your risk to reward ratio appropriately.
Many traders agree that next to maximizing profits, the second most important thing for them is minimizing losses. A trading system that wins only 50% of the time on average can still be profitable. Most of the traders want to make money but dont know how to protect what they currently have.
You have 50% chance of the forex market going your way and 50% chance of going against you. It is just like flipping a coin. Suppose the trade does not develop in your favor and the market is going against you. You should cut your losses by using stop losses. In nutshell, you cut your losses and let your winners run. This simple 50/50 currency trading strategy earns a profit even when a novice trader might experience a loss.
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.
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