Risk V.S Reward
How to determine risk - reward ratios?
The first step you want to do is determine the amount of money you want to risk. This should be determined by your overall account size. typically I recommend you risk anywhere between 1-3% of your account as your learning the art of trading. Lets say you start off with a $10,000 account risking anywhere between 1-3%, your potential loss should be $100 - $300.
If you have a $5000 account and your risking 1% on a trade, your potential loss or draw down on that trade should not exceed $50. If your risking 3% on that account then your potential loss or draw down should not exceed $150. Now if you are looking to risk $50 or 1% on that trade risking , you should me looking to gain at least 1% -3% ($50 -$150) potential gain. This is where risk - reward ratios come into your trade. Before you even enter you trade you have to plan it. Where you entry is gonna be and where your stop loss is going to be placed, then you have to look at potential take profit areas.
Lets say your risking 1% on a trade, with a 1:1 risk reward ratio, your risking 1% to gain 1% which is acceptable. The most idea risk reward ratio you should try and aim for per trade is a 1:2, Risking 1% for a 2% gain or a 3% risk for a 6% gain.
Risk Reward Ratios
In the example above, this trade demonstrates a long position with a 1:1 risk reward ratio. The red box is the potential risk and the green box is the potential reward. The stop loss is 10 pips and the take profit is 10 pips. This type of risk - reward ratio is acceptable but not ideal.
In this example above, this trade demonstrates a 1:2 risk reward ratio. 10 pip stop loss and a 20 pip take profit. This type is risk - reward ratio is great. You should try and aim for at least a 1:2 risk - reward ratio every trade if the opportunity presents itself.
In this example, This is a risk - reward ratio of a 1:3 which is amazing, 10 pip stop loss and a 30 pip potential reward. If most of your trades can hit a target of a 1:3 then that will increase your chances of consistency and profitability. Normally 1:3 risk - reward ratios can be achieved with medium to long term swing trades.
This is an example of a BAD risk - reward ratio. In this trade, there is a 20 pip risk for a 10 pip reward. This is a horrible way to trade and is part of poor money management. avoid taking trades that give you a bad risk - reward ratio at anytime. only wait for trades that provide a 1:2 risk reward ratio or more.