Hello and Welcome to the ditto educational series that will provide you with the skills you need to become a forex trader!
What is a Risk-Reward Ratio and how does it apply to us?
The concept of risk and reward is a basic one! It is simply a ratio of how much you are willing to risk in any given trade, versus how much you plan to aim for as a reward.
Let’s Put this into a easy to understand formula ,if you were looking to place a trade and you only wanted to set your stop loss at ten pips for example! then we could set your take profit to forty pips, your risk-reward ratio would be 10:40 or 1:4. You are risking ten pips for the opportunity to gain 40 pips. Simple right!
The basic concept for your risk-reward ratio is to look for opportunities in the market where the reward always outweighs the risk. This concept is not singularly applicable to forex but universally known in all industries that profit with risk.
When your rewards always equate to more than your losses you can afford to withstand more losing trades generally speaking within reason. If you make 10 dollars per trade when you close in profit and only lose 2 dollars per trade when you close negatively, you can afford to have 5 losing trades to every one winner in order to break even.
The point of using a healthy risk-reward ratio is to always tip the odds in your favor. If you consistently traded at the pre-mentioned ratio, you could lose half of your trades, and still, make a steady profit.
Now we will touch on to one of my favourite topics in forex and perhaps one of thee most important subjects that will have its own educational video separate to this one.
Typically, risk-reward is most useful when the market price is near prominent support or resistance areas. We discussed candlesticks surrounding these areas and now maybe you are starting to see how all of this information is coming together.
For example, if Any given pair is in a overall downtrend and price has tapered off near resistance and could be showing a lower high in accordance with price action, the risk reward concept could be applied here and would likely favor a sell trade with a smaller protective stop above the entry and a larger take profit in the direction of the trend.
What Sort of Risk Reward Ratio Should we use?
As always The type of risk-reward ratio that we end up using will depend on the type of trader you are going to be, and factors such as volatility and market conditions can also play a role.
It would be fantastic if you could always find high probability trades that have a high reward and low risk ratio, but what you might find in reality is that it may be unrealistic for certain types of traders.
For example a swing trader will always be taking less trades than a day trader and over longer periods. They have a safer and more patient strategy generally with larger risk reward outlook.
In terms of ratio we never want to have have a risk that is larger or equal to the reward. Some traders may thrive on this during volatile market conditions but as a general rule risk always equates to less than reward.
The reason behind putting a stop loss in place on our trades is not only to protect our capital but also to stop your trade when it is no longer behaving in a way that reflects your analysis. There could be many factors why your trade is not behaving as you originally thought it would. but accepting the predetermined loss over exacerbating the loss is always the best choice.
At the end of the day, it is always up to you as a trader to find out what type of risk-reward ratio will suit your pre determined trading style.there is no one shoe fits all ratio when speaking in terms of individual trades, traders or strategies. The important part to remember is that you use a ratio that is right for your trading style and for the current market conditions.
Never let the market take more for you on a trade that you’re looking to taking from the market and always stick to your trading plan, as a bad plan can be adjusted easier than a undisciplined mindset.
I hope you enjoyed today’s video ladies and gentlemen please sit back and contemplate what you have learned as always contemplation is the key to learning.