Traders who consistently apply risk/reward ratio calculations to every trade position are more likely to achieve consistent profits. While you are free to choose any trading strategy, setting appropriate risk and reward levels can enable you to achieve consistent profits even if your trading strategy is not yet fully developed. Implementing a risk/reward ratio gives traders an equal opportunity to secure consistent gains, making it a 'holy grail' in trading alongside discipline and emotional control.
Setting Risk and Reward Levels
The first step in setting up your trading strategy is calculating the risk you are willing to take to achieve realistic trading results. A common mistake is to determine the reward first or to set the stop-loss level too close to the entry level, which disrupts the strategy. Based on forex market price probabilities, you should first determine the risk and then calculate the reward as a multiple of that risk. Effective risk management will yield consistent profits in trading. Reward levels are typically set at 1, 2, or 3 times the risk. Similarly, when using a trailing stop method, the stop-loss level should be adjusted to 1, 2, or 3 times the predetermined risk level.
Example of Risk and Reward Levels
Consider the EUR/USD on a 1-hour chart. A valid pin bar confirmed by daily resistance and bearish momentum provides a strong sell signal. The stop-loss level is set at the highest point of the pin bar, 1.3656, which is one pip above the pin bar’s peak. The entry is made at the lowest point of the pin bar when it breaks, at 1.3611, one pip below the pin bar’s low. The total risk is 45 pips. Using a mini lot where 1 pip = $1, the risk is $45. The reward level is set at 1, 2, or 3 times the risk, translating to 45 pips, 90 pips, or 135 pips.
On a daily chart of XAG/USD (silver), a bullish fakey pin bar gives a buy signal. The risk is set slightly below the pin bar at 113 pips. The reward levels are at 1R (1 times the risk), 2R (2 times the risk), or 3R (3 times the risk). With a mini lot, where 1 pip = $1, the total risk is $113, with corresponding rewards of $113 (1R), $226 (2R), and $339 (3R).
Trailing Stop
To maximize profits, a trailing stop method is applied at each reward level. The exit level doesn’t have to be at the reward level, but the stop-loss must be adjusted at each reached reward level. This ensures profits if price movements align with predictions. This method is effective in strongly trending markets. For instance, on a daily chart of AUD/USD, by applying the trailing stop method, the stop-loss is set at the break-even point after the price surpasses the 1R level. If the price continues to rise and surpasses the 2R level, the stop-loss is moved to the 2R level, and so on. This approach allows for maximum profit according to the trend, potentially achieving profits up to 4R or even 5R.
Consistent Profits with the Risk/Reward Method
Ideally, the risk/reward ratio should be set at 1:1 or 1:2 for every position opened. This means that the average loss/profit ratio is 1:2. When this method is correctly applied, it leads to consistent trading profits. For example, if in an overall trading scenario, 65% of trades are losses and only 35% are profits, with a risk/reward ratio of 1:2 and a total of 100 trades, there would be 65 losses and 35 profits. If the loss per trade is $100, the total loss is $6500. With the reward being twice the risk, or $200, the total profit is $7000, resulting in an overall profit of $500.
A common mistake traders make is failing to execute trades with the discipline required by the planned risk and reward levels. By rigorously applying the risk/reward ratio method to every position and complementing it with a sound trading strategy, the risk/reward ratio can truly become the 'holy grail' of trading.
The risk/reward ratio is a crucial component in forex trading that helps traders achieve consistent profits. By setting appropriate risk and reward levels and adhering to them with discipline, traders can maximize profit opportunities even if their trading strategy is not yet perfect. Maintaining flexibility and continually developing the trading plan are keys to success in the dynamic forex market.
