Using the proper risk to reward ratio is what turned my Forex trading around. Like many traders, when I started back in 2014, I was attracted to the trading strategies that made me feel “safe”. By safe I am mostly referring to the scalping strategies that have a 120 pip stop loss and a 12 pip profit target.
Essentially risking $120 to make $12. Of course, I wasn’t thinking in terms of dollars risked back then, only pips. I later realized (after A LOT of struggling) that I had it all backwards. So let me break it down for you.
The key to being a consistent Forex trader relies on two things:
- Finding your edge AKA stacking the odds in your favor
- Using the proper risk:reward ratio, Of course, there are other factors that come into play, but if you master these two you’ll be well on your way!
The Golden Rule of Risk to Reward ratio
So what is a “proper” risk to reward ratio? The golden rule is to never risk more than half of the potential profit. In other words, if your target (reward) is 100 pips away your stop loss (risk) cannot be more than 50 pips away. This enables you to maintain a minimum of a 1:2 risk to reward ratio, where “1” is your risk and “2” is your reward. Of course, the ratio can be greater, such as a 1:3 risk to reward, but never less.
This prompts an important conversation piece. It isn’t enough to just say, my target is 100 pips away so I’m going to place my stop 50 pips away on the other side. It has to be strategic. Let’s take a look at an example.
First, let’s get a feel for the pin bar setup that had formed and then we’ll get into the specific risk to reward ratio. Here’s the general trade idea. Note that the market had also been trending up for more than a year when this bullish pin bar formed.
As you can see, we have an uptrend (higher highs and higher lows), a key level now acting as support and a well-defined bullish pin bar. The last thing we have to check is the risk to reward ratio to make sure it fits our criteria. Here’s how we would figure out the risk to reward ratio for this trade.
As you can see, the stop loss, in this case, is 50 pips from the entry. On the other hand, the target is 105 pips away from the entry. This satisfies the 1:2 R:R minimum. In reality, you would need to identify a logical target based on the key levels you’ve identified. Once you have the target you can then figure out if the setup presents a favorable R:R based on where your stop loss would need to be placed.
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Just remember, any setup that has a 1:2 risk:reward ratio or better is fair game. It may be tempting to take a trade that presents an 80 pip target and a 50 pip stop loss, but if you did my first question to you would be, where does it end? It can be a “slippery slope” as they say once you start bending the rules.
I’ll be the first to admit that I break a rule every now and then, but this is one rule that I never break no matter what. That’s because I’ve witnessed the power of using a proper R:R and the drastic improvements it has made to my trading.
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