01 July, 2020, | AtoZ Markets - Forex trading as a retail level is different from the institutional level. However, you need to identify a trading strategy with a proven track record when you trade alone or trade with other people's money.
Why is the proven track record vital?
It is essential because the forex market is associated with uncertainties. So, it is important to set a trading strategy that can give you profit overtime with all market conditions.
However, the trading strategy does not mean a method to buy and sell only. It consists of money management, trade management, emotional bias management, and risk-reward ratio.
You may earn a decent profit with your trading strategy, but it is possible to lose all of your earnings in a single trade.
Have you ever tried to take a trade without a stop loss?
If you tried, you would know how painful it is when the market goes against you. In this situation, some traders panic, and they re-enter the trade with the hope that the market will reverse. However, the reality is very harsh. You cannot eliminate the trade to go against you, or no one can save your balance from going to zero. Even Warren Buffett or George Soros cannot come and keep your trade profitable. The only person that can save your balance is you. Therefore, to do this, you need to follow a profitable trading strategy with an appropriate risk: reward ratio.
What is the Best Risk-Reward Ratio?
The risk: reward ratio is the ratio between your desired profit and the risk that you are willing to take. For example, you analyzed the market and found that the EURUSD pair has a higher possibility to move up at 1.2050 from 1.1050. Therefore, you took a buy position in EURUSD at 1.1050. Moreover, you have analyzed that the buying possibility will remain as long as the price is above the 1.1000 level. In your trade, you are taking 50 pips of risk for 100 pips of reward. So in your trade, you took 1:2 risk: reward.
Remember that a small risk with higher reward is always profitable. However, there are other things that you should consider while measuring the risk-reward ratio.
In the following section, we will see the calculation of the risk-reward ratio and the process to match it with the trading strategy.
Calculation of The Best Risk-Reward Ratio
As we have mentioned earlier, before proceeding to the risk-reward ratio, you need to identify a trading strategy that has a proven track record by doing backtesting. By using the proven track record, you can see how profitable your strategy is. Some trading strategy is very secure but provides a smaller profit while some trading strategy is risky and provides enormous profits. So what will be the best risk-reward ratio for your trading strategy depends on the profitability of your strategy.
The reward risk ratio is the distance between your stop loss and your take profit from your trading entry. If the distance between your entry and stop-loss is 50 pips and the gap between your entry point and your take profit level is 100 points, then the reward risk ratio would be 2:1
The formula for Reward Risk Ratio:
RRR = (Take Profit – Entry) / (Entry – Stop loss)
Minimum Winrate Calculation:
If you know the reward: risk ratio for your trade, you can calculate the minimum required win rate with the formula mentioned- below:
Minimum Winrate = 1 / (1 + Reward:Risk)
Example 1: If you enter a trade at 1:1 reward: risk ratio, your win rate should be more than 50% to be a profitable trader:
1 / (1+1) = 0.5 = 50%
Best Risk: Reward Ratio Guide for Traders
In this section, we will see guidelines about how you can achieve the best risk: reward ratio for your trade.
Support And Resistance
We know that support and resistance are horizontal lines or zones. These levels are essential as big players use this level to start or end the price movement. If you see the price of your currency pair is heading to the resistance, you may expect that it will come down after rejecting the resistance level. Therefore, if you are in a buying position and the support level is lower than your expected profit level. Therefore, you need a higher risk for a smaller return. In that case, you need to avoid trade and consider buying other positions when the price is near any support level. Similarly, consider selling positions when the price is just below any resistance level.
In the image above, we can see how taking trade from a support or resistance level can give you the best risk-reward ratio.
Fibonacci Extension Level
All we know, Fibonacci is used as an essential tool to predict the price movement. If you want to take a trade, you can identify the potential risk and reward level using the Fibonacci extension. In any retracement based trade, any trading entry from 50%, 61.8%, and 23.6% retracement would give a better result. On the other hand, if you want to set the take profit of your trade, you can use 100% or 161.8% as a target level. Therefore, you can evaluate the risk: and reward and consider the trade when the ratio supports your trading strategy.
Chart Pattern
Chart patterns are shapes that form from the price movement in the forex market. Price patterns indicate a significant market movement, and allow you to take the best risk: reward from a trade. There are both price continuation and reversal patterns that indicate the price to move sharply after breaking it.
For example, in the image above, we can see how the price moved up after breaking the price pattern. Moreover, as the movement from the price pattern is sharp, you can take the trade with a smaller risk only.
Conclusion
There are many traders who can make profitable trades but are still struggling to make money. The only reason is that they are ignoring risk management from their trading strategy. On the other hand, most of the successful us have the best risk-reward ratio for their trading strategy. Therefore, if you want to see your name on the list of successful traders, you need to make sure that you have a profitable trading strategy. Therefore, you are following a suitable risk-reward ratio for it. Overall the Forex Market is associated with risks that we cannot eliminate. Therefore, when the market is giving a profit, it is your job to take the maximum benefit from the market.
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