Forex trading carries an element of risk, but also has the potential of delivering great rewards. Therefore, success in forex trading is all about balancing risk and reward. For us to get an understanding of the concepts of risk and reward in forex, we have to identify what constitutes risk, and what constitutes reward.
The Concept of Risk
What constitutes risk in forex? Risk in forex can be looked at in terms of the following:
- Leverage used in trades
- The stops used in trade protection
- Trade volume
Forex trading is a leveraged activity. This is because the movements in forex are really very small and need to be magnified by using large trade volumes. Due to the fact that most traders could not afford the large sums needed to generate trade volumes that will magnify the value of the pip movements, leverage was introduced as a means of providing extra capital needed by these traders. However, leverage is a double-edged sword. While it can magnify trade profits, it can also magnify losses. The degree of profits or losses is not usually in proportion to the trader’s margin; it is in the full measure of the trade capital amount which includes the leverage used.
The stop loss used in trade protection constitutes another element of risk in forex. Measured in pips, the degree of risk a stop loss poses to a trade is equivalent to the trade volume (lot size) used in the trade and the number of pips used in setting the stop loss. So if a trader sets a stop loss of 100 pips for a trade and uses a lot size of 0.1 lots, then the risk to the trade is $100. Recall that the value of a pip movement for a trade of 0.1 lots is $1 (10,000 X 0.0001), where $10,000 is the monetary value of a position of 0.1 lots and 0.0001 is the value of 1 pip in percentage points.
The last element of risk in a forex trade is the lot size/trade volume. This will have a direct bearing on the monetary value of a pip as well as the leverage.
The Concept of Reward
The reward for a forex trade is the profit that has been made on any trades placed on a forex account. Reward in forex is also a product of three factors:
- The Take Profit settings
- The trade volume/lot size
- The leverage
Unlike binary options or other forms of fixed return investments, forex is an investment vehicle which produces a variable return. What this means is that the level of return seen in a forex trade is a product of the number of pips by which the trade has moved in the trader’s chosen direction. Therefore, the forex trade setup must be engineered in such a way that as many pips as possible can be attained before contrarian factors cause the asset to reverse its movement.
The lot size of a trade also has a bearing on the monetary value of the trade’s reward. Therefore, a trader who sets up a trade with 1 Standard lot size and makes profit will earn $10 per pip movement, while another trader with a lot size of 0.5 lots will earn $5 per pip. However, the lot sizes must be used responsibly so as not to expose the trade to too much risk.
The use of leverage will also have an impact on the reward derived from trading activity. However, leverage is a two-edged sword and therefore must be used responsibly as well.
How Can Risk and Reward Be Used Effectively in Forex Trading?
The overall profitability or otherwise of a forex trader is a product of the balance between the risk and the reward. Since the aim of every trader is to make profit, the ability of the trader to reap rewards that far outweigh the risks of a trade will depend on how these two factors are managed.
Losses in forex are inevitable. Therefore, the essence of trading is not for ALL trades to be profitable but to ensure that the combined profits that are made from the profitable trades can offset the losses from the losing trades, even if the number of losing trades exceeds the number of profitable trades.
In other words, aim to only trade setups where the potential profit will far outstrip the potential loss. For this to happen, you need trades that can deliver a minimum of 3 pips in potential reward for every 1 pip risked as stop loss. These targets should be set according to the support or resistance levels that are prevalent on the chart. In other words, let the closest support guide the setting of the stop loss and the closest resistance guide the setting of the profit target, and take the trade if the profit-stop loss ratio is 3:1 and above. At the very minimum, a 2:1 ratio is acceptable. For this to happen, trade orders must be made as close to the key support (long trades) or resistance (short trades) levels so that there is enough room for reward and little room for risk.
Benefits of Choosing Trades with High Reward and Low Risk
The benefits of only trading setups which offer potential for a high reward when compared to the existing risk can be best explained using the numbers.
We will use the example of 2 traders: John and Jerry. John trades 20 times a month, and makes only 8 successful trades. Jerry also trades 20 times a month, and makes 13 successful trades, yet John ends up with more money that Jerry for the month. How is this possible?
John only takes trades where he can potentially make 3 pips for every 1 pip set as stop loss. So if all John’s trades are set with 50 pips as Stop Loss and 150 pips as Take Profit target, and John had only 8 successful trades, then the combined profit would be 8 X 150 pips = 1,200 pips. His losses would be 12 X 50 pips = 600 pips. Net profit for John = 1,200 – 600 = 600 pips.
Jerry is not as prudent as John and does not consider how much reward he can potentially get when compared to the risk he is assuming. He has several trades where risk-reward ratio is 1:1, and only 3 where risk-reward is 1:2. He also uses 50 pips as stop loss. 8 losing trades will mean a loss of 8 X 50 pips = 400 pips. 9 winning trades with 1:1 risk-reward ratio is 9 X 50 pips = 450 pips. 3 winning trades with 1:2 risk-reward ratio is 3 X 100 pips = 300 pips. Net profit for Jerry is (300 + 450) – 400 = 350 pips.
John ends up with 600 pips profit, while Jerry is left with only 350 pips. We can see clearly that even with fewer profitable trades, John still carried the day because each winning trade delivered a high return when compared to Jerry’s winning trades. Some traders who setup trades where the risk outweighs the rewards will end up not making any profits at all because the larger losses will offset any profits made from several trades.
The Risk-Reward Calculator
There are several calculators online designed to assist the trader calculate the risk-reward ratio for every forex trade.
The most basic of such tools will ask you to enter a figure for risk and reward. What you should do is to look at the immediate key level of support or resistance that will dictate your stop loss or take profit targets, then calculate the number of pips it will take your trade to get from opening price to either the stop loss (risk) or the take profit area (reward). Enter these figures in the correct spaces and click on the automated calculator. The risk-reward ratio will be shown. Use this to determine if the trade is worthwhile or not.