Hello and welcome to another edition of the bulls vs the bears. Last week we touched on Put In Your Risk You Get Your Reward. This week we are going to learn how to calculate your risk reward reward ratio without blowing your trading account. It’s absolutely crucial that you get get this part or else your trading account will be history.
I’m sure some of you rookie traders have been struggling with risk reward ratio for ages. Newsflash! Even experienced traders are totally clueless about how to calculate risk ratio reward before making their trade entry.
So basically we are going to learn the whole process of calculating risk reward ratio. This will help you understand how important calculating risk reward ration is to your money management strategy. I guess the question everybody is dying to get answered is:
How Do I Calculate Risk Reward Ratio?
The formula seems fairly straightforward. Let’s say you decide to risk 40 pips and you set a profit target of $80. Your risk to reward ratio is 1:2
Your risk(40 pips)to reward($80)= 1:2
Fairly simple. Isn’t it? However, when calculating your ratio, keep in mind the commission your forex trader charges you every time you enter a trade. Failure to pay attention to the spread could cost you an inaccurate risk reward ratio. Not to the mention the fact that it could distort your trading account also.
Let me break it down nicely. Let’s say you’re the type who only risk 5 pips per trade in the hopes of racking up 10 pips per trade. Amd you think you ‘ve hit the 1:2 jackpot, you need to rethink your trading strategy.
Say your broker charges you 2 pips every time you trade the EUR/GBP pair. This means you are risking 7 pips(5+2) to make pips(10-2), which nets you a ratio of 1:14. Not the same as 1:2. Is it? The rationale of this scenario is that you need a higher win rate to compensate for this huge risk reward differential. By the way the win rate is the percentage of winning trades you need to maintain to remain profitable.
This huge differential affects scalpers (Those who trade for short term gain) and day traders. But for the swing and position traders, they’re sitting pretty since the trade on higher time frames. This huge differential could bite even harder especially if you set tight stop losses and profits. Now let’s take a look at an illustration of the risk reward ratio using the GBPJPY pair.
Here we have a price action chart comprising of a 100 pip stop loss and a 200 pip profit target. if we calculate the risk reward ratio for these fundamentals the result will be less scary. However, if your broker hit with a 5 pip spread here is what the risk reward will look like:
105 (100+5) pips risk and 195(200-5)pips gives us a ratio of 1:85 How do you get a such a delicious ratio? It’s because the trade was in a higher time frame. This type of ratio works works perfectly if you are into swing trading or position trading, you are in luck. Like mentioned earlier, these two trading categories work perfectly in higher time But if you are a scalper looking to make a quick buck, you could end up playing catch up, not to mention, blow up your trading account.
Relationship Between Win Rate and Risk Reward Ratio
Your win rate has everything to do with your risk reward ratio. I dare say your win rate plays a huge part in your risk reward ratio analysis. You need to figure out your win rate before even thinking about your risk reward ratio. Here is a simple formula you can apply if you want to continue racking up the profits.
What’s The Formula?
It goes like this: Required Win Rate = 1 ÷ (1 + Historical Risk to Reward Ratio of Your Trading Strategy)
Let’s say your expected risk reward ratio is 1:1. If you plug into the above formula, you should get the following result:
1 ÷ (1 + 1) = 0.5, which is 50%.
This means that you need to be averaging 50% profits just to breakeven. Anything above 50% should make your trading account smell like a rose. But if the average dips below 50% expect a loud groan from your trading account. Because regardless of how you perform in the short term, you will hemorrhage all your money.
However, there is a way out of this. If you are able to establish a win rate of 50% on a 1:2 ratio, you should be able to make 50% on your capital. All you have to do is to risk 1% of your capital – nothing more nothing less.
Another formula you can implement is:
Minimum Risk To Reward Ratio
You use this formula to calculate the minimum risk to reward ration you will need to stay afloat or stay profitable : Here is how the formula goes:
Required Minimum Risk to Reward Ratio = (1 ÷ Historical Win Rate of Your Trading Strategy) – 1 is
Let’s say your historical win rate 50%. IF you plug 50% into the above formula, this is what you get:
(1 ÷ 0.5) – 1 = 1
Judging from the above result you need to maintain 1 risk reward ratio of 1:1 in order to remain profitable. Meaning that if you set a stop loss if 100 pips your profit target should be 100 pips. The preferable ratio among most traders is 1:2. So if you set a stop loss of 100 pips you should set a profit target of 200 pips. Mind you, these targets are not etched in stone. I’m just using them as illustrations of how to set your risk reward ratio.
You Can Use A Calculator To Calculate Risk Reward
If you find calculating risk reward ratio is too taxing for your brain cells, help just arrived. And it’s called a calculator. Just calculate your risk ratio on your calculator and give your brain cells a break. Also look out for free mt4 indicators on google. These tools are also useful for calculating your risk reward ratio.
If you prefer something more specific look for an fx(forex) calculator online. Just go on google and you should see the search results for fx calculator on your screen from top to bottom. But if you are scared of calculators you can fall on on the tried and tested Microsoft Excel sheet. That should help simplify the calculation process.
Fibonacci Retracement Tool to Identify Risk To Reward Areas
Another tool that can help you identify your risk reward areas is a famous retracement tool called the Fibonacci Retracement Tool(or Fibs a forex traders like to call it). The fibonacci tool was originally created to define levels of huge price swings. Let’s look at a few examples
As you can see you can identify your risk to ratio areas using custom levels such 1.2,3, 4, e.t.c. So you label the risk to ratio areas RR1 RR2 RR3, e.t.c. RR represents the risk areas. Just remember that these levels only serve as reminders of potential risk to reward price levels of your trade. They are not actual calculations of Fibonacci ratios.
Now let’s try to use the Fibonacci to identify potential risk reward levels .
You see the red diagonal line at the bottom of the chart? That’s the Fibonacci tool turned upside down. The blue lines streaking across the chart represent the Fibonacci levels which you enter in your MT4 software. As you can see, the stop loss at the bottom is labelled 0 while the buy entry is labelled 100, These two levels symbolize the potential risk to reward ratios.
Right above these fibonacci levels is the potential risk to reward areas labelled RR1 and RR2 respectively
So with the Fibonacci tool you should be able to create a nice picture as to what price level your trade will produce a decent risk to reward ratio. Pretty exciting stuff. Isn’t it?
That’s a wrap for ” How To Calculate Risk Reward Ratio Without Blowing Your Forex Trading Account. ” Calculating risk to reward is a breeze so long as you have a grasp of how the fundamentals of risk to reward ratio work. However, make sure you access the risk reward ratio of every trade you intend to enter in prior to entering your trade. Regardless of the tool you you use to do your calculation, You absolutely have to do your due dilligence or you will get your fingers burnt severely.
Even more important, you need to understand the relationship between risk to reward with your chosen trading strategy. Then spend as much time as possible testing as many risk to reward ratios a possible to establish the best risk to reward fit for your trading strategy.
Once you find a risk to reward combination you are comfortable with, you then calculate the minimum win rate required based on your chosen risk reward ratio . In so doing you can keep a better eye on the success of your trading strategy.
Till next time take care.
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