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What is risk to reward ratio?


Nick Robinson

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Nice question Nick, let me try to answer you in the best manner possible: 

The main difference between an amateur trader and a professional one is that the professional trader always understands and manages his portfolio's risks. Many investors use a risk to reward ratio so they could compare the expected returns of a trade with the amount of risk (money in) they must undertake to earn these returns.

The risk to reward ratio helps traders manage their risk of losing money on trades. Even if a trader has some profitable trades, he will lose money over a long period of time if his win rate is below 50% if he does not properly manage his risk. The risk to reward ratio shows the difference between a place where the trade was taken to the traders stop-loss and a sell or take-profit order. Comparing these two shows the ratio of reward to risk. Most traders use stop-loss lines when trading individual stocks in order to minimize losses and directly manage their trades with a risk/reward focus. A stop-loss is nothing else than an automatic order to leave the position if the trade does not go your way. 

Let me give you an example:

Let's say we want to buy a stock at its current price, as we expect it to go up. Let's say that the current price of the stock is $1000. So we bought 1 share of the stock for $1000, and we think that there is a great chance for it to jump 20% up in price! However, if it fails to do that, it will most likely lose you a lot of money. So what we want to do is set a stop-loss at some form of a support level, which we (as an example) found at $900. If we put a stop-loss at $900, it gives us a downside of 10%. With a 20% upside, and a 10% downside, this trade gives us a 2:1 reward to risk ratio. 



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Hey Nick,

Making a profit in the long run through Forex trading is a process that takes time, patience and commitment. Simply opening a position without properly managing the trading risk can easily affect your invested capital in a negative manner. 

Forex risk management is a very popular topic among traders. First of all, traders want to downsize the potential loss, but at the same time, they also want to maximize their profit out of a single trade. It’s well known that bigger profits come with bigger risks. That’s where proper risk management comes in. Knowing certain tools and techniques and how to apply them can easily help you avoid loss and fully commit to your trading activities.

The risk/reward ratio is used to measure a potential profit of a trade in relation to the potential loss. In other words, it evaluates the difference between the moment you’ve entered the market to stop-loss and a sell or take-profit order. Comparing the two represents the risk/reward ratio.

A useful technique that will help you control risk is knowing when to cut losses. This method can be carried out with a "hard stop", where traders will lock in a stop loss at a specific point. Another way to do it is a "mental stop", where traders decide to limit the drawdown they’re prepared to take on a trade. Basically, it’s telling to yourself that you will quit a certain point. 

Another way to properly manage risk is to avoid large lot sizes. Inexperienced traders are advised to start with smaller lot sizes, providing them with bigger flexibility in managing trades. Nowadays brokers may advise you to open an account with $200 and use high leverages to facilitate mini lot trades of thousands of dollars and double your profit in a single trade. But this can easily turn out to be a reckless move.

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Hello Nick,

Risk/reward ratio determines a trader’s possible earnings by gauging an investment’s possible loss. For instance, a 1:4 risk/reward ratio represents a trader’s willingness to commit $1 and gain $4. Therefore, divide the returns by the risk to calculate the ratio.
The win rate is also worth mentioning. It’s a percentage representing the impressions achieved from scheduled purchases divided by the total bids. Suppose you bid 10 times and win twice, your 20% win rate is derived as follows: 2/10 X 100.
As such, more losses call for huge winners. Even so, don’t sacrifice your risk/reward for your win rate. Prioritizing gains over risk management could still throw you in the red. Though you can safeguard your capital with a stop loss, ensure it doesn’t block potential earnings.
That’s why your ratio should match your trading strategy. Practice reveals sensible risk/reward ratios for your trading method. Because the market is unpredictable, only place sums you don’t mind relinquishing. On top of that, manage your emotions and trust your technique.
 

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