How To Use Risk/Reward Ratio Effectively In Forex Trading

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How To Use Risk/Reward Ratio Effectively In Forex Trading

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When I begin to learn about Forex, many experienced traders told me that Risk/Reward (R/R) ratio is one of the best ways to manage money in trading. At first, I didn’t believe what they say and used other methods to get rich more quickly. Despite having a win rate from 60-70%, I kept losing money and burned a lot of accounts.

After one year, I decided to change my mind and tried to use the Risk/Reward ratio. And it turned out what they said was true. This method helped me a lot to keep my money safe and make profits gradually. Instead of getting rich-quick, I’m doing it slowly and safely now.

In this article, I will share all my experiences about how to manage money (capital) according to the R/R ratio. What is the reasonable rate of 1R? How to improve R/R ratio? Or why are its difficulties?

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What is the Risk/Reward ratio?

Risk/Reward Ratio (also known as R/R ratio) is simply understood as the ratio of the money you’re willing to lose in exchange of the profits you want to earn in 1 trade.

For example, I open a BUY EUR/USD order with 40 pips stop loss and 120 pips take profit . So in this case the ratio R/R = 1:3. Or in other words, in this trade, if I’m wrong, I will lose 1R. But if I’m right, I will win 3R.

What is the Risk/Reward ratio?
What is the Risk/Reward ratio?

Usually, to determine how much money 1R is, people will base on the total money in your trading account (account balance).

For example, your account balance is $1,000. You choose 1R = 2% of the capital. So if you are wrong, you lose 1R = $20. Conversely, you will gain $60$ when winning.

Or you can change 1R = 5%, with R/R = 1:4 for 1 trade => If your prediction is wrong, you will lose $50. And when you win, you will earn $250.

In practice, professional traders often choose 1R = 2%. Why is 1R = 2%? You can check the 2% rule article to know the reason.

Some ways to use the R/R ratio in practice

Traders who use R/R ratio to manage money usually have a table summarizing their transactions (trading log). If they lose a trade, they will record -1R. On the contrary, if win, they will record +2R, +1.5R… depending on the amount earned.

Trading log with the Risk/Reward ratio
Trading log with the Risk/Reward ratio

And in the end, what it all boils down to is making as much R profit as possible. Now I will share some ways to use the R/R ratio effectively.

Prioritize orders with a high R/R ratio potential

In a word, to start the trading day, I browse through certain currency pairs, analyze and predict their price trends. Then, I find the entry points, stop loss and take profit. From there, I will have an overview of the R/R ratio of these pairs. The ones with a low R/R ratio will be ignored. Those with high R/R ratios will be prioritized for monitoring and trading.

Prioritize orders with a high R/R ratio potential
Prioritize orders with a high R/R ratio potential

Take for example the image above. The EUR/JPY order will be prioritized to trade because its ratio = 1:4 (best compared to the others).

Usually, long term traders will prefer this approach. What they need to do every day is quite simple. Take a little time, look at the overall market for each currency pair, pick a few pairs with a high R/R ratio and focus on them. When all the conditions have been met, they will enter the order.

Only trade with a certain R/R ratio

Simply put, you will choose a certain R/R ratio such as 1:2, 1:3 or 1:4 or even higher.

Trade with a certain R/R ratio
Trade with a certain R/R ratio

I give an example of a trader who loves the Risk/Reward ratio = 1:2. If the expected profit is not enough 2R, then he will pass. On the contrary, if any currency pair gives a chance to trade at a ratio of 1:2 or higher, he will consider opening a trade.

Often this approach will work for Day Traders, who spend most of their time looking for trading opportunities in the market.

What Risk/Reward ratio is reasonable?

Answer: The win rate will determine the R/R ratio.

For instance, your Forex trading method has a win rate = 50% (trade 100 orders, 50 wins – 50 losses). So you only need 1 ratio = 1:2 to make profits (50 x 2R – 50 x 1R = 50R).

On the other hand, if the win rate is only 30% (trade 100 orders, 30 win – 70 lose). So for the account to be profitable, the ratio must be 1:2.5 or more => (30 x 2.5R – 70 x 1R = 5R). 5R for 100 orders is too small.

What ratio is reasonable?
What ratio is reasonable?

In reality, many traders make money with a win rate of about 30%. But every time they win, they make a lot of Rs in profit. After all, they’re still profitable.

Remember that our goal is to make as much R profit as possible. Therefore, calculate the winning rate carefully to be able to give a reasonable R/R ratio.

How to improve the R/R ratio?

Patience and patience

Optimizing Stop Loss is the best way to increase the R/R ratio. I will give you two specific scenarios.

Scenario A: Price breaks out of the resistance and goes up. If you enter a BUY order right now, your stop loss level will be 80 pips => If the price goes up 160 pips, the ratio is 1:2.

How to improve the R:R ratio?
How to improve the R:R ratio?

Scenario B: You wait patiently for the price to retest the resistance zone and enter a BUY order. At this point, your SL is only 60 pips => If the price goes up 160 pips, then the ratio is now 1:2.6.

Do you understand what I mean? The more patiently you “bargain” with the market for a better position, the better the R/R ratio will be.

Long-term perspective change

Assuming you analyze the market in a small time frame (15 minutes or 1 hour), you will see a short take profit point.

Change to trade with long time frames
Change to trade with long time frames

Try changing the timeframe on the chart you analyze (4 hours or days). You will see bigger waves, longer Uptrend or Downtrend cycles. From there, your take profit point will also be much longer. This will help improve your R/R ratio.

Evaluate the Risk/Reward ratio

The two key points that traders always find difficult when using this ratio are psychology and discipline. Let’s take a look at some of the pros and cons of this way of managing capital.

Account status

Similar to the 2% rule, the advantage of the R/R ratio is that your account status will never fall into a case of big loss. Your money will still be there, and opportunities will always come for those with money.

Account status when managing money with the Risk/Reward ratio
Account status when managing money with the Risk/Reward ratio

In this market, what you need to do is survive and adapt. If you can survive after a long time and still do not lose all money, you will earn profits naturally.

Profit taking psychology

All I write above is basically talking on paper. To use the Risk/Reward ratio effectively, you have to experience and go through hundreds of big and small battles in the market.

In the beginning, if you just simulate this way of managing capital and expect the same results, it’s not that easy. It’s because everyone’s mentality is different.

You may know it is normal for the price to go against the prediction and your order hits stop loss. But on the contrary, assuming the price goes in the right direction, the feeling of waiting for take profit is really terrible. It’s like you’re afraid a robber is staring at your pocket. At this point, you might make the wrong decisions.

Profit taking psychology example
Profit taking psychology example

For instance, the above is a beautiful BUY EUR/USD order with an expected R/R ratio of 1:2. The price has only increased half of the way, then the trader begins to feel afraid. He closes the order when the price has not reached the take profit level. From 1 trading order with the ratio = 1:2, it is now just 1:0.8

The psychology of waiting for TP is one of the barriers of capital management with the R/R ratio. When you are wrong, you lose 1R. But when you are right, psychology makes you not earn enough 1R. If you can’t solve this problem, your balance will lose gradually until it reaches 0.

Discipline is the most important part of Risk/Reward ratio

All traders who use the R/R ratio know its rules. “1R = 2% of the account and each trade is not allowed to lose more than 1R”. Or “Don’t trade when R/R ratio is lower than 1:2”. There are many other sayings. But not many people can obey the rules strictly.

Plenty of them get caught up in the market, forget what they learn and throw away the rules. And in the end, they leave the market with empty hands.

Remember that R/R ratio is good but it’s nothing without discipline.

Conclusion

Risk/Reward ratio is another great way to manage your capital to survive and make profits in the market. Personally, I also see a lot of traders choosing it as a guideline in their risk management strategies.

To actually master the R/R ratio is a long process. What you have to deal with are patience and discipline. It’s not as easy as you are reading my article.

Let’s experience it in a Demo account. I have already shared all things I learn and experience in this article. Goodbye and see you again in the next ones.

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