Forex risk reward ratio strategy – how it works
That's the best risk to reward ratio Forex strategy? It's logical to say that the best strategy gives you crazy rewards and the smallest risks, right? — wrong. There's a lot to take into account before deciding on the best risk to reward ratio. For instance, let's say you are only trading setups that have 1 risk and 10 reward ratio. On paper 1:10 seems amazing, however, how often can you find trading setups that can give you such a ratio? What is the success rate of trading the setup? You might spend a whole year glued to your screen and never see a trading opportunity with a 1:10 ratio.
Consistently profitable traders care less about what will happen in any single trade. They care about what will happen after hundreds of trades. Risk to reward and success rate are both highly important in this regard. The main goal of trading is to make money after a series of trades. As we've already mentioned, RR and success rate are decisive in profitability. Let's discuss each in more detail:
Risk to Reward Ratio and success rate
Let's discuss two scenarios to better understand how to select risk to reward ratio for our trades:
Scenario 1: Let's say you are trading Doji or some other trading pattern that has a 50% success rate, in other words, the price can go in any direction. In order to make money trading this setup in the long run, your rewards need to be greater than risks. Keep in mind that there are also trading and non trading fees that need to be covered. Ideally, when the success rate is 50%, the risk to reward ratio should be 1:2 or greater.
Scenario 2: Let's say you are trading a trading setup that has a 60% success rate. In other words, on average, 6 out of 10 trades close in profits. In this case, you can use a 1:1 risk to reward ratio and still make money in the long run.
How to spot risks and rewards
It's not recommended to open trading positions when you do not see Stop Loss targets. However, this is not so obvious in the case of profits. Often, trading patterns give traders entry signals, well-defined stop loss targets but not clear profit targets. This is especially true for trend trading patterns and indicators. When you join a strong trend, would you exit whenever you reach the profit target, just because your risk to reward ratio says so? Of course not. A professional trader would ride a strong trend instead of simply exiting. It's justified to open some trades that do not show clear profit targets. In general, these setups give traders general expression and most patterns offer greater than 1:1 risk/reward ratios.
Reasons to modify R/R targets after entering a trade
In general, it's not recommended to touch Stop Loss and Take Profit orders once they're placed. Once a trader opens a position, his/her psychology changes. Human emotions such as doubt, fear, greed, excitement, etc. become much more powerful and can overshadow the ability to clearly judge the situation.
However, there are cases where it's more beneficial to change the reward target. Traders that ride strong trends have tools and techniques that enable them to find exit points. Some use trailing stops that lock in profits. Others partially close their positions and exit gradually. Managing a successful trade is more difficult than a losing one, as it takes more precision and focus.
When it comes to changing the Stop Loss target, it's a highly dangerous and totally terrible idea. One of the main reasons why traders blow up their trading accounts is that they increase their risks while hoping the price will reverse. It's recommended to never touch your stop loss once in a trade. Or at least have clear reasons for it
Practical use of risk and reward ratio
It's hard to find the best risk to reward ratio in Forex. Ultimately, it all depends on the trading setup. Today you may find a setup with 1:2 ratio and tomorrow with 1:4. Decision-making becomes more complex when we are including success rate in our analysis. To make it simple, most traders avoid opening positions that have 1 risk and less than 1 reward ratios. In addition, traders also avoid trades with less than 50% success rate. In order to increase the success rate, traders are integrating various indicators and fundamental analysis tools. It's worth mentioning that the more tools and indicators you use to confirm a trade direction, the more precise the trade will be, however, over-usage of indicators can also have negative effects. Traders that take too many factors into consideration are experiencing analysis paralysis extremely often. Trading should be effortless and simple.
Understanding the risk ratio in Forex, and its effect on your results can improve your skills. Risks and rewards play a major role in risk management. To trade consistently profitably, it's important to trade setups that have the proper level of risk to reward ratio. In addition, it's critical to never take huge sized positions. Professional traders usually risk up to 1 to 5% of their trading capital per trade. When positions are oversized, profitability gets dependent on luck and not on probabilities. What's more, it's critical to note that risk management also involves managing traders' emotions. All of these aspects, when managed properly, produce amazing results.
Risk to reward ratio for trading precious metals
When trading precious metals as CFDs, it's crucial to figure out the right balance between risk and reward. There's no one-size-fits-all perfect ratio, as it varies based on factors like the situation, market conditions, your comfort with risk, how likely you think a trade will succeed, your trading plan, and how long you plan to hold onto the investment.
Active traders who frequently trade precious metals usually go for a 1 (risk) to 1.5 (reward) ratio. On the other hand, investors who prefer taking fewer trades but aim for substantial gains tend to use higher ratios, often 1:5 or even more.
Risk to reward ratio for trading shares as CFDs
The factors influencing the optimal risk-to-reward ratio for trading shares as CFDs are akin to those discussed for other financial instruments, encompassing considerations such as volatility, trading frequency, and risk tolerance. However, it's noteworthy that stock prices exhibit distinctive movements compared to Forex pairs.
In the realm of forex markets, the valuation of one currency in relation to another prevails, with currencies being tied to nations and their respective central banks. Consequently, currency markets often follow cyclical patterns and trade within defined ranges. In contrast, stocks operate with greater flexibility, offering traders abundant opportunities for favorable risk-to-reward scenarios.
Share prices often respect significant levels, providing traders with the potential to engage in breakout and reversal strategies. This unique characteristic of stocks allows for impressive risk-to-reward ratios, with opportunities to achieve ratios as notable as 1:5 or even 1:10. This distinct behavior in stock movements enhances the prospect of identifying and capitalizing on advantageous trading opportunities.
Risk to reward ratio for trading Crypto derivatives
Determining the optimal risk-to-reward ratio for crypto CFD trading hinges on one's approach and chosen strategy. Crypto assets, known for their high volatility, prompt brokers to offer conservative leverage for trading crypto derivatives.
Scalpers, who engage in frequent trading, often opt for 1:1 or 1:1.5 ratios. Their strategy involves securing modest profits per trade while executing multiple orders due to the rapid pace of their transactions. Swing traders, on the other hand, tend to favor 1:2 or even higher risk-to-reward ratios, capitalizing on the broader price swings over a slightly longer timeframe.
For trend followers, the approach differs. While adept at identifying entry points and stop placements, they often lack a predetermined exit strategy. Trend followers aim to ride trends for maximum profit, employing techniques like monitoring fundamental events, identifying continuation and reversal patterns, and conducting technical analysis.
Unlike strict take profit rules, trend followers might move Stop Loss orders into profit with a 1:1 ratio or use trailing stops once a trade sharply moves in their favor. Their focus is on understanding the trade's potential before initiating it, aligning with the dynamic nature of cryptocurrency markets. The adaptability in risk-to-reward ratios reflects the diverse strategies traders employ when navigating the complexities of crypto CFD trading.