A Few Words About the Ratio
Not a single complete risk management system can do without the established risk-to-reward. Even with a perfect market analysis, sooner or later you will go negative if you ignore this rule.
So what is it? From the title, it is clear that this is the ratio between the potential profit and loss volumes. Let’s say, you set a Stop Loss 20 pips away from the open price and Take Profit 60 away. Then the ratio is 1:3. If you set both levels at the same distance from the open price then the potential profit and loss will be equal.
At some point, you may want your profit to exceed losses 10 times. But what are the chances that the price will make such a leap? By setting Take Profit 10 times farther from the entry point than Stop Loss, you are almost 100% likely that your trade will close at a loss.
Setting Stop Loss too close is also a bad idea. Due to the constant price fluctuations, your transaction may hit the SL level just before it turns in the direction you need. That is why it is important to give the price a small space for a maneuver.
The Benefits of This Rule
When you open a trade you know that it will either work out or not. That’s why your chances of winning are approximately 50%. If the profit and loss on your transactions coincide, then on average you won’t make a dime. But you did come to Forex to earn money, right? That means you need to enlarge the percentage of your profit.
This is precisely what the risk-to-reward ratio gives you. If your profit on the transaction exceeds the loss by at least 2 times, then to cover two failed transactions you need only one profitable one. And after one profitable position and one losing, you still make money.
Calculation of the Ratio
You may act in three different ways:
- You choose SL and TP and check the ratio of the distances to both levels. Usually, this method is used when a trader sets entry and exit points according to key price levels. In this case, you should establish the minimum ratio in your trading plan and enter into a transaction only if the rule is met. That is, if your plan indicates a ratio of 1:3, then you should not enter into a transaction if the profit is less than three times the loss.
- Stop Loss is set according to your strategy or technical analysis and Take Profit is set according to the risk-to-reward ratio from your plan. That is, if the ratio should be 1 to 2 and Stop Loss is set 30 pips from the entry point, then set Take Profit at a distance of 60 pips.
- In some cases, Take Profit is calculated using a special formula. For example, if you trade on gaps, then the TP is set at a distance of 1.5 times the distance to Stop Loss. For such unique cases, the ratio from your trading plan may be slightly different from the strategy itself.
If you use technical analysis in trading, then for sure you will use the first way. In this case, you will need to follow three simple steps:
- Set a Stop Loss. You can use any strategy convenient for you. As a rule, traders use the nearest price levels, such as resistance, support, and moving average.
- Set a Take Profit. Use the same levels as in the previous paragraph.
- Measure the distance from the entry point to the set levels and divide the potential profit by the potential loss. The resulting number should reach your minimum. That is, with a ratio of 1 to 3, you should get a difference of at least 3.
How to Set the Right Ratio
You already know that with a ratio of 1:1 you will remain at a loss. This is because, as a rule, the volume of losses on a transaction usually exceeds the amount of income.
To make a profit your absolute minimum should be at least 1 to 2. The optimal ratio is 1:3. Exceptions are unique strategies such as gap trading described above.
Once you have chosen the ratio for yourself and entered it into your trading plan, your success will directly depend on the implementation of this rule. If you move away from it, then the plan will not work and you will fail. Build a plan and follow it steadily. Only in this case, you’ll reach success.