Risk/Reward Ratio

In financial trading, the risk to reward is a ratio that simply compares a trade’s potential risk versus its potential reward.

It is used by traders to determine the long-term viability of a trading system.

First and foremost, it’s important to note that there is a universally adopted risk/reward ratio.

A lot of inexperienced traders often ask the question what risk/reward ratio they should use for their system.

This depends on what type of system one is trading. In fact, determining the correct risk/reward ratio is part of the system itself.

Specifically, the risk/reward ratio is calculated by comparing the potential risk versus the potential reward.

Remember, even though when trading there are also inherent transaction costs such as spread and commission.

Longer-term traders aren’t really affected by this, due to the costs being almost negligible compared to the actual profit targets stop losses.

How to Weigh Risk/Reward Ratios

Meanwhile, a trader scalping the lower timeframes on the one-minute chart is much more affected by the spread.

For example, a scalper might be seeking a buy on the GBP/USD aiming for a quick 6 pip profit target, with a 3 pip stop loss. In this case, we have an initial reward risk ratio of 2:1.

The problem is, if the forex broker quotes the GBP/USD spread as just a couple of pips, in real terms, the trader would need 8 pips, thereby approaching a reward risk ratio of 3:1, and considerably more arduous to achieve.

Whatever one’s reward risk ratio, the question the trader needs to ask is, are the percentage of losses reaching such a level so as to wipe out the gains generated by the system.

However, traders need not set fixed immovable stops and targets, since market conditions are always changing, which often demands adjustments.