The Risk-Reward Ratio

The risk-to-reward ratio is a fail-safe mechanism used by many forex traders to protect themselves against both catastrophic losses and a slow bleed-out of capital via many small, losing trades. By forcing each winning trade to reach a predetermined level of gains, and restricting each corresponding loss to a predetermined level, as well, technical traders seek to stack the forex trading deck in their favour.

The rationale is that, if a specific trade is forecast to earn a certain level of profit, the risk assumed by the trader should then be restricted to a percentage of that potential gain. An example would be a risk-reward ratio of 3:1, meaning that for every dollar the trader risks losing, he expects to earn three.

For an example of the risk-reward ratio in action, note the chart below. This is the hourly chart of the pound sterling versus the U.S. dollar, currency pair GBP/USD:

Pound Sterling Vs. U.S. dollar

The price action is currently bouncing between the 200-time period moving average and a weak resistance line at 1.5725. The most recent candlestick formed is a shooting star, signalling a potential reversal back toward the MA-200’s support. This is a bearish trade set-up.

The MA-200 is currently near 1.5650, giving a profit forecast of 75 pips (if the trade is entered precisely at the resistance line). For the hypothetical trader with a 3:1 risk-reward ratio, that potential profit should be divided by three and the stop loss placed that distance (25 pips) from the opening price.

So how well does the system work? That’s determined by several factors:

• How well does the trader follow the system? Traders face abundant temptations to cheat, both by riding a losing position in the hope the price action will turn, or by exiting a winning position to protect the gains achieved. Both methods undermine the risk-reward ratio.
• Is the trader technically good? In other words, can the trader spot a winning trade and accurately forecast his winnings or calculate his loss?
• How good is the trader’s luck? Limiting losses is all very well and good, but if the trader’s luck is lousy, a sustained run of losses can still wipe out his starting capital.
• Does the market cooperate? If trading conditions suffer from thin liquidity or a volatile political landscape, a trader’s positions can be wiped out and losses accumulate through no fault of his.

A trader should never enter the market with the expectation of taking a loss, and it’s only prudent to quantify those losses, as well as the gains, in advance. However, the risk-reward ratio trading method carries two inherent dangers:

• The stop loss has no relationship to the underlying chart or market reality, and may as well be selected from thin air.
• It’s tempting for many traders to apply the risk-reward ratio to the largest possible gain, rather than a more realistic or conservative one, and therefore risking far more capital on the trade than is necessary.