You will find a plethora of articles online referencing risk reward ratios in FX trading. Sadly the majority of these articles are written by bloggers, webmasters and/or professional paid writers – all of whom have little to no trading experience! Truthfully many of them have never placed a live (or demo) trade in their lives!
As former dealers/traders we have many years of trading experience which allows us to share our deep knowledge with you.
So, back to risk reward. One of the worst habits that any trader can adopt is: “running a loss and taking a profit too quickly”. It is a proven fact for many to sit on a bad position, watching tick by tick going against you and seeing your loss get larger and larger. Invariably you have a “level” where you will “get out” which you raise (or lower depending whether you are long or short) based on “a feeling”.
Then, when the position turns and starts to be in profit, many traders close their position for a small gain! Sound familiar?
Basically you are prepared to take a sizeable loss or a small profit! It does not make sense does it? You should be looking to take sizeable profits with minimal losses – this is where a good risk reward ratio comes into force.
Adopting a risk reward ratio i.e. placing a take profit and stop loss on an open trade ensures you are maximising your profit and minimising your risk.
So what is the correct risk reward ratio? Is it 1:2, 1:3, 1:5, 1:10+? The answer is………. Dependant on your trading strategy, market volatility and the pair you are trading! Basically, there is no standard ratio (one size does not fit all!).
As we stated above you should always be prepared to make more than you lose – a no brainer yes! So a 1:2 ratio is the minimum. However it really depends on volatility and the pair you are trading.
For example: trading in a pair with larger spreads like EUR/NOK, which can be between 15 and 50 pips, adopting a 1:2 ratio is likely to result in being stopped out almost immediately. Your opening position is always “marked-to-market” i.e. the profit/loss of a position is calculated against the current market bid/offer. (many brokers only permit stop loss orders a “minimum” distance away from the current market price – so be careful!)
So the wider the spread the larger the risk reward ratio.
However that does not necessarily mean that a tight spread means you can adopt a smaller risk reward ratio! Invariably the tighter the spread the more “liquid” the pair and the more likely that there will be “real money” i.e. true institutional flow moving the market. This can result in “spikes” when very large volume enters the market and the good old fashion laws of supply and demand kick in. However, in general terms anything better than a 1:2 ratio should be advisable.
“No one size fits all” – true but it is advisable to have at least “a size” in place dependant on your own trading strategy and risk tolerance. Having traded majors for many years I have found that adopting a 1:3 (at least) risk reward ratio suits my trading style/strategy. I know I can walk away from an open position with the comfort that any potential loss or profit is controlled. If I only profit in 30% of my trades I am in the black (70 pips lost against 90 pips gained) adopting a 1:3 ratio.