What are risk/reward ratios in FX trading, and which is best suited for you?

• A risk/reward ratio, or simply R:R ratio, is a risk management tool that ensures the level of risk on a trade is never greater than the risk, aiming to ensure long-term profitability.
• While the reward is the potential gain if price hits your take-profit, the risk is the amount you stand to lose if the trade hits your stop-loss order.
• The right risk-to-reward ratio for your trading will depend on personal preference, but it can also depend on the strategy, its win rate, and a trader’s technical analysis technique.

The secret to being a successful trader isn’t necessarily about being right; it’s about making the most of your profitable trades, while being able to protect your account from unreasonably large losses.

In other words, managing how much you stand to gain, versus how much you stand to lose from each trading opportunity - otherwise known as the risk-to-reward ratio.

Let’s discuss.

To best explain what a risk-to-reward ratio is, let’s start by defining each term:

• Risk: This is the maximum, pre-defined amount a trader is willing to lose if the trade is unsuccessful and hits a stop-loss. This can be either a fixed dollar amount, a percentage of the total account value, or a value in pips.
• Reward: Should a trade be successful and hit a take profit order, this is the amount a trader stands to gain. Again, this can be either a fixed dollar amount, a percentage of the total account value, or a value in pips.

In the context of the above, risk/reward ratio, often simply referred to as R:R ratio, is a risk management principle that determines the attractiveness of a trading opportunity by comparing the potential risk to the potential reward:

Risk:reward ratio = potential loss:potential profit

To help explain, let’s break down some commonly chosen ratios within trading:

• 1:1 risk:reward - In this scenario, the amount of risk is perfectly equal to the reward. For example, if a stop-loss is placed at -50 pips, a take-profit order would be placed at +50 pips.

• 1:3 risk:reward - Amongst the most commonly used, a R:R ratio of 1:3 would dictate that for every pip risked, you stand to gain three pips. In actual terms, this would mean a take-profit order would be placed at three times the distance from the current price than the respective stop-loss order.

• 1:5 risk:reward - While challenging to achieve consistently, a 1:5 risk-to-reward ratio means that the potential gain from any individual trade will always be five times higher than the risk. Using a dollar amount as an example, this would mean that if your trade is successful and your take-profit is hit at +$500, a stop-loss order would need to be placed at -$100.

Put simply, the higher the ratio, the more favourable the trade, but the more challenging it is to achieve consistently.

It should be mentioned, however, that this concept is not infinitely scalable. While the above suggests that a higher risk-reward ratio is always better, in reality, you are likely to achieve a much lower win rate when aiming for a more ambitious price target.

For example, the idea that you can risk 10 pips and stand to gain 200, at an effective R:R of 1:20, is excellent on paper, but in practice, markets are exponentially more likely to move 0.5% in your favour versus 10%. For the same reason most traders don’t predict price action thousands of pips away, the same applies to choosing a risk-to-reward ratio.

While selecting the appropriate level of risk in relation to the reward, your win rate also plays a key role in determining your long-term success as a trader.

Say your trading strategy aims for a high R:R ratio of 1:5. While tough to consistently achieve, with your price target set five times the distance from the current price compared to your stop-loss, this would mean you can afford to make five losses before a single win and still break even.

Effectively, this gives you the ability to break even with a win rate as low as 20%. While, in reality, most fine-tuned trading systems offer win rates significantly higher than this, strategies with a lower win rate are best used in conjunction with a higher risk-to-reward ratio, where the profits from one successful trade far outweigh multiple losses.

While ultimately, this will be a matter of personal preference and comfort level towards risk, traders should also consider the following:

• Trading style: Your style of trading will often determine which R:R ratio you should be using. Those looking to hold positions for a short amount of time are usually better suited to use a lower ratio, since larger price movements to meet higher risk-to-reward targets tend to take longer. On the other hand, traders who are more comfortable holding positions for more extended periods, such as swing or position trading, may opt for a larger ratio.
• Market structure & analysis: In line with your analysis, traders will have an idea of where the price could go in the next move. For example, if you are day trading and, according to your analysis, the price could either rise by 60 pips or fall by 20 pips to a level of support, this would suggest an appropriate R:R is 1:3. This technique can also be used to filter which trading opportunities are the most lucrative.
• Win rate: As mentioned above in more detail, the win rate of your strategy plays a role in determining the correct risk-to-reward ratio to use. Naturally, techniques and forms of analysis that offer lower win rates are better suited to higher R:R ratios, and vice versa.

While maintaining a consistent risk/reward ratio is a valuable technique when managing account risk, here are three things to remember:

• While the reward is the potential gain, risk is the potential loss should the trade hit your stop-loss. In line with general trading wisdom, to be profitable, we need to make sure that we maximize potential gains while limiting against excessive losses, with R:R ratios being a valuable tool in achieving this.
• While an individual trader will choose the correct risk-to-reward ratio based on their own personal appetite to risk, the type of trading strategy, its win rate, and their own analysis will also determine which ratio to use.
• Higher R:R ratios, although lucrative on paper, are exponentially harder to achieve. Most traders would consider 1:5 as a maximum, although this will ultimately come down to personal preference and trading strategy.

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