Risk-Reward Explained

How to Use Risk-Reward when Planning your Forex Trades

hotforex.webtraderIn the forex markets, the trader must put in some money into the venture in order to get any kind of returns.The trader uses some of his capital/account balance to purchase a currency in the hope that the currency purchased will gain in value against the other currency it is traded against. This is the element of risk assumed by the trader.

It is risk because the play may not work out as planned. When this occurs, the trader will walk away with less money than was initially invested. However, without taking on this risk, there is no way the trader gets any returns or a reward thereafter. Therefore, in forex without the element of assuming risk, there is no reward whatsoever.

In forex, the process of forex trading involves putting a portion of the trading capital at risk by purchasing a currency, with the expectation that the currency purchased will either gain in value and deliver profit when resold (long position), or lose value when sold to a counter party (another trader or the market maker/dealer) who will now need to pay the trader more of the initial currency in order to get back the exchanged one, resulting in a bountiful reward.

What specifically constitutes the risk factors in the highly leveraged forex market?

RISK:

The movement of currencies in the forex market is in the order of one-thousandths or one-ten thousandths of a point, usually known as a pip. Therefore, large volumes of trade are required in order to convert these small movements into reasonable returns. In order for this to happen in an environment where there is enough trade liquidity, forex brokers introduced the concept of leverage, allowing traders to control these large positions with a small amount of money. So while a standard lot trade requires $100,000 investment in a position, in reality the trader only needs a few hundreds to a few thousands, depending on the leverage chosen used by the trader.

Risk Factor 1: While the leverage may magnify the profits, it will also have the effect of magnifying losses if the trade goes bad. So leverage in itself is a risk factor.

Another risk factor is the stop loss chosen by the trader. The stop loss is a tool used to control the degree of loss sustained in the event that a trade goes against the trader. This is measured in pips. Any number set as the stop loss will become an additional risk factor in that trade. If the trader sets a stop loss at 50 pips, then the risk to the active trade is 50 pips. But how does this translate into monetary terms?

Depending on the trade volume used by the trader, 50 pips may translate into $100, or it could translate into $5,000! Whatever the case, any loss which has been cut short by the stop loss is the risk factor that the active trade has assumed.

Risk Factor 2: The stop loss is the risk incurred in an active trade.

What can transform a loss that could ordinarily have been $100 into a loss of $5,000, even when the 50-pip stop loss setting has remained constant? This is where we mention the third risk factor, which is the trade volume.

Trade volume is measured in lot sizes. So a position size may be expressed in monetary terms as the trade volume, or may be expressed in lot sizes. So a position size of 0.1 lots (1 mini lot size) is equivalent to $10,000 (trade volume). Ramping up trade volume is one strategy traders use to get magnified returns from trades. But like the two edged sword it is, using high trade volumes can also magnify the losses sustained in the trade, and this can end with disastrous consequences for the trader.

Risk Factor 3: The use of high trade volumes can increase the risk to a trade and compound losses.

Now that we have identified the risk factors in forex, let us establish what the reward is.

REWARD:

The reward is simple: profitable trades that will deliver pips in profit territory and money in your account. The following factors will work to produce a reward for the trader:

Reward Factor 1: A certain distance from the trade entry point in the direction of the trader’s expectation is chosen. This will be the level at which profits can be captured automatically once that level is attained. This is the Take Profit level and is the opposing factor to the stop loss. The Take Profit (TP) must be at least two times the stop loss. Anything less is unacceptable!

Reward Factor 2: Believe it or not, a carefully chosen leverage will work in the trader’s favour to constitute a reward factor. A maximum leverage of 1:100 is accepted widely as the limit of leverage that will be safe for the account.

Reward Factor 3: In order to translate reward factors 1 and 2 into monetary terms, an acceptable trade volume must be used commiserate with the maximum allowable risk percentage of 3%, generally accepted by market experts as the safest risk exposure for retail traders.

…Putting It All Together

Risk and reward is not just about one-off trades. It is about being able to end the month in profit territory. The concept of risk and reward must also factor in the inevitability of trade losses at certain times. The trick is to aim for more reward per trade versus risk exposure, so that a single profitable trade can only be offset by at least 3 trades to attain breakeven.

How is this achieved? This is achieved by being able to select trades with risk-reward ratios of 1:3 and even higher. A minimum of 1:2 is allowed as the worst possible case scenario, so a trader who sets 30 pips as stop loss can aim for 60 pips in profit.

But does this mean the trader should simply set a profit target at three times the distance, whatever the stop loss is? This is not the way to go. Rather, aim to enter trades as close to key levels of support or resistance that will enhance the trade. This will allow the trader to set stops that will not suffocate the trade, but at the same time, allow the trader to use achievable profit targets that will deliver the appropriate risk-reward ratio.

1:3 Risk-Reward Trade

Look at this chart below:

risk reward chart

We have a retracement LONG entry at the 38.2% area based on the Fibonacci-Stochastics retracement trade parameters (price at Fibo level where Stochs is oversold is entry area for long trade). The entry price is 1.2890. The logical place to set the stop would be just below the 50% area at 1.2838. This gives a stop loss of 52 pips. So we would be aiming for at least 104 pips profit (1:2 risk-reward ratio) or even 156 pips profit (1:3 risk-reward ratio).

The Take Profit from this trade is set using the Fibonacci Expansion tool as shown below:

risk reward 2

The first target area is therefore the 61.8% Fibonacci expansion area at 1.3076, and we see that price eventually got to this area for a profit of 186 pips.

risk reward calculator

Using an online risk-reward calculator, we see that this is a ratio of 1: 3.57, a very good return on investment. This can only be attained by setting long trades close to a support area or a short trade close to a resistance, so that the stops can be made tighter and the trade have enough room to make profit.

Adam

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Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

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