Reward to Risk

The reward / risk (reward to risk) is the ratio between the potential gain and the potential loss.

Example: We have a profit target of 50 pips, and a stop loss of 25 pips. Our reward / risk ratio is 50/25 = 2:1. Our potential gain is twice our potential loss.

It is better to trade when you have a high risk to reward ratio. The higher the ratio, the less you have to be right. In other words, you increase your chances of trading profitably when you have the potential to make more than you are risking.

For instance, if you give yourself a 3:1 reward/risk ratio, you have a significantly greater chance of ending up profitable in the long run. Take a look at this table as an example:

You can see that even if you only won 50% of your trades, you would still make a profit of $10,000. Whenever you trade with a good reward to risk ratio, your chances of being profitable are much greater even if you have a lower win percentage.

However, we've noted a major flaw in most Forex trading education material on reward / risk. This has led to many forex traders misunderstanding the concept.

The problem with the traditional reward to risk ratio is that it ignores probability theory.

Let's illustrate:

Risking, say, 30 pips (stop loss) to make only 17 pips profit seems risky, right? Why? Because this is less than a 1:1 reward to risk ratio.

But would we consider it risky if the trade stood an 80% chance of being profitable? This is where most forex traders get it wrong.

With 80% probability of success, the reward to risk ratio is really 2.26 to 1.

Here's the simple calculation: (17 pips x 0.8) / (30 pips x 0.2) = 13.6 / 6 = 2.27/1

(Note: 0.8 represents the 80% chance of success. 0.2 represents the 20% chance of the stop loss being hit.

It is crucial that you incorporate probability theory to calculate the reward / to risk ratio of your trades.

The probability of profit or loss, of course, is a function of your strategy.

In the above example, if your trade stood only 50% chance of success it wouldn't be worth risking 30 pips to make 17 pips profit. This is because the reward / risk ratio would be 1 / 1.76 ((17 x .5) / 30x .5)).

Get the point?