Assessing Risk-Reward Ratios for Forex Trading

Naturally, many forex traders focus on how not to lose money, and this is an important part of a risk management strategy when trading.

Nevertheless, while no one ever went broke taking a profit, a number of traders have gone out of business due to insufficiently positive returns since they could no longer justify the time spent trading, or perhaps their spouses or business partners pulled their support for the business.

This illustrates why assessing the relative value of several different types of risks involved in your trading business against the rewards that you plan on achieving can make good sense. This is especially true for a thoughtful trader who wants to stay in the forex trading business over the long run.

The Risk Reward Ratio of Your Business

In order to gain a suitable assessment of the business risks that you may face when trading forex, you can perform a risk/reward analysis. The steps to go through when performing such an analysis might go something like this:

  • Step #1 - Research Possible Risks :You will first need to do enough research into your new business so that you can effectively foresee any potential risks that may arise.
  • Step #2 - Estimate Potential Losses and Rewards: Now reasonably determine the potential financial loss that you might incur as a result of the risk coming to pass, and the potential financial rewards that you hope to earn from currency trading.
  • Step #3 - Probability-Weight Potential Losses and Rewards: Then, weight each risk and reward by your best estimate of the probability of it actually occurring in your particular situation to get a set of probably-weighted potential losses. Sum these weighted losses up to get a total loss number, and do the same with the weighted rewards.
  • Step #4 - Compare Risks to Rewards: Look at the sum of the weighted potential losses and compare it to the sum of the weighted potential rewards. This will give you a risk/reward ratio that you can use to see if your currency trading business makes sense.

    • Common Risk Reward Ratio Guidelines

    To provide a general guide, most successful traders will not enter a trade unless the risk they foresee for it is less than half of what their anticipated reward will be.

    This means they have a 1:2 minimum Risk/Reward Ratio criterion for any trades they will consider entering. Other more patient traders will only pull the trigger on a trade if they see a trading opportunity with a 1:3 risk to reward ratio.

    Make Sure Your Business Measures Up

    Basically, after performing a probability-weighted risk/reward assessment for your forex trading business, you should see a similar chance of success or better.

    If not, then be sure to ask yourself why would you want to enter such a business in the first place since your valuable time might be better spent elsewhere.