When you are starting to get into Forex there are some a couple areas you need to pay big attention to one is risk management and the other is risk to reward ratio which also falls under risk management. If you are making trades and winning 9 out of 10 this isn’t as much of a problem. You can profit greatly and only win 6 out of 10 trades however with good risk to reward ratio.
So how do you calculate risk to reward ratio? There are different ways to do this but the simplest way is to look at pips. If you have a 25 pip stop loss (risking 25 pips) and your take profit is 50 pips your risk-reward ratio is 1:2 or you are risking 1 pip for every 2 you make.
Figuring out how much you are going to risk in order to get your reward will mainly come down to the strategy you use. For a longer-term trading that could be risking 100 pips to make 200 pips which is still 1:2.
If you can get your risk to reward ratio up to 1:3 or 1:5 that is where you can really starting making a return. There really isn’t going to be a set pip risk to reward with longer-term trades since your stop loss will usually be back to the last high or resistance/support area.
For example in one of the longer term strategies I now use your take profit is to the 50 moving average line which also moves constantly for the trade. The stop loss is usually above/below the last high/low.
So when I am calculating the risk reward I always want it to be at least 1:2 on these longer term trades.
But of course this strategy works on most all time frames so guess what the risk-reward will differ on every single time frame. If you want to see this free strategy you can click here or click the link in the menu and it will take you there it is a great way to get started and demoing in forex.
Also with long-term trading you usually don’t have to worry about spreads from your broker which is a fee basically and they can be anywhere from around 1 pip to 2 pips normally. I go into depth on spreads here.
Short-Term Trading Or Scalping
Risk to reward in scalping can range quite a bit and that is for usually bad reasons. I have seen strategies which I would never think about using where traders risk 20 pips to make 3-5 pips? This is just not right in my opinion. Having a 4:1 risk reward ratio would be just to stressful because you are going to lose in trading it will happen no way around it. That is why proper risk management is key to a traders survival.
Most scalpers have around a 1:1 or 1:2 risk to reward which is fine if you are consistently winning. Scalping can be stressful because of this that is why you see people going to longer term trading. You can probably make more as a scalper because you are entering and exiting more trades instead of seeing that pullback on a longer-term trade you are actually making money off of it.
Where scalping can hinder you is with broker spreads and fees. Where if your broker is hitting you up with a 2 pip spread each trade and you are only getting 10 pips you are actually only winning 8 pips so it is something to think about. This can be one of the negatives with scalping vs longer term trading.
The way I personally trade with scalping (I call it shorter term trading or new paradigm trading) is always at least 1:2 risk reward. But I use a 10 pip hard stop loss and a 4-5 pip manual stop loss. So what does this mean? Let’s say I risk 2% I put that 2% into that 10 pips but if I lose I only usually lose around 1% or less. This is what is called new paradigm trading and I won’t go to much into since I am still mastering the technique but it is a fun way to trade.
With this way of scalping I do get out or leg down my profits but I will also let the trade run if it is in my favor. So where a longer-term trader might be making 2% every 100 pips if I am able to catch that trade at the right time I could make 20% in that same amount of pips (2% every 10 pips). I am not saying this always happens but 20% return in one trade is a beautiful thing and a couple of those a month and you are on your way in a hurry.
How Many Trades Do I Need To Win With My Risk To Reward?
With any strategy you are going to want to see what your win rate needs to be in order to be profitable. This is actually pretty simple with a formula we have found.
So let’s say you stick to the minimum 1:2 risk to reward ratio.
1 / (1 + REWARD) = WIN RATE NEEDED TO BE
For this example we would do a 2 for the reward
1 / (1 + 2) = 0.33 or 33%
So with a risk reward of 1:2 you would need to win 33% of the time to stay about BE minus spreads. Realistically you can win 50% of the time and do just fine trading at a 1:2 ratio. You only need to win 55% of the time to be profitable with a 1:1 ratio as well but I wouldn’t consider that.
This is where forex can be a lot of fun with not having the pressure to win every trade which creates emotion.
In the long run you need to figure out what kind of risk to reward is going to work for your you. Always remember your stop loss is your profit regulator. Using a 50 pip stop vs a 10 pip stop can make a big difference over a volume of trades. I am talking 10’s of thousands vs millions.
The other way to look at something like that is you have to use the stop loss that works for your lifestyle. If you can’t be on the charts an hour or 2 hours a day then you may want to trade something long term where you will be executing on the 4 hour charts. This way you can check on your trade ever 4 hours at most and you will need to use a much bigger stop loss.
However if you can devote 1-2 hours a day to charting and set up some alerts on trend lines and be able to jump on and execute trading the New Paradigm may be for your. You don’t have to only pick one. I trade longer term and short term depending on the time I have available.