Best Forex Risk Management: Optimizing the Reward to Risk Ratio

Risks at Forex are caused by the structure of the market. It is the sphere of the most severe competition of the capitals, special knowledge, and human characters.

For some reason, many people do not spend enough time analyzing their Forex trading decisions. A sad study from Statistic Brain says that 80% of all Forex traders lose money over the course of 6 months of active trading.

Want to avoid the fate of those 80%? Learn about a simple way to improve your Forex risk management plan to start looking at each of your investments from a more objective point of view.

Whenever you start thinking about investing money, you take into consideration many factors including the size of investments, possible returns, and risks.

The relationship between the last two is quite important to evaluate the effectiveness of any investment properly. There should be a term for it. It exists and it is not that fancy.

This article is for those who have come to the financial market to work and to earn steadily, and it means that:

• you have a correct understanding of the market`s structure, and, in particular, from where money appears at the market and where they “leave” then;
• you realize a possibility of the losses even before the opening of the first transaction;
• you have made competent Forex risk management as a basis of the trading strategy.

 

What does Forex risk management mean?

• understanding (or identification) of all possible risks for each transaction;
• the correct assessment of the risks to which the transaction is exposed now;
• planning (the maximum elimination) of risks which can be avoided without essential loss of profit;
• continuous monitoring of a situation from the possible losses point of view;
• fast effective actions for the risk reduction if the price has gone against you.

 

The Reward-to-Risk ratio

The meticulous planning that allows us to gain calculable profits always involves the reward/risk ratio calculation. There is no better way to look at the large picture objectively and understand whether you should invest your money.

The Formula

The ratio can be easily calculated by dividing a potential reward by a potential risk. The result you get is your ratio. The higher the number, the better chance your investment is going to bring you considerable profits.

This ratio is only a small aspect of a much bigger analytical process that involves a lot of important calculations. Math can be scary but not in our case.

When analyzing Forex risk management strategies, you should consider a multitude of factors.

Calculating the reward-to-risk ratio is quite easy and diverting.

Here’s an example:

You spend some time looking at the movement on the chart and see a good opportunity to gamble on an upcoming price correction.

You measure all the lines carefully and expect that the correction should take place within a couple of days and return back to the previous position. You expect a possible return of $100 while your potential loss could reach $1000.

Here is the calculation:

$100/$1000 = 0.1 which translates into the 0.1/1 ratio.

For the vast majority of situations, this is a very bad investment. Most reasonable investors will not invest until they can reach the reward-to-risk ratio of 4/1 or at least 2/1.

You could exclaim that it is impossible to earn $2000. However:

You can always set a stop-loss point to mitigate further risks. The risk can be adjusted according to your specific situation. In our case, we can simply set a stop loss at $50. It means that the actual investment is only $50, therefore the ratio now is:

$100/$50 = 2 which translates into the 2/1 ratio.

This is a more reasonable scenario. The prospect seems absolutely positive. You lose only $50 but you can get $100. This sounds like a great deal. The problem is that there are many other important factors that should be taken into account when analyzing your Forex risk management strategies. You can play with this and many other scenarios in Forex Tester.

Many Faces of Investment Analysis

The timing, length, and probability of the positive scenario should all be accounted for. The price might stagnate at a certain level for a long time meaning that your trading account will be “locked” for an extended period of time. This may also reduce the effectiveness of investments even if you earn those $100.

The main idea is that you should not rely on a single formula. It’s better to use it only as part of a much more expansive analytical process.

Incorporating Risk and Reward for Your Trading Account

We all know that there is no reward without a risk in Forex trading. One simply cannot eliminate risks from the equation and get nonchalantly from $100 to a villa on a sunny beach. You have to evaluate each step carefully and think about when and where you should take a risk to get an appropriate reward.

We have to take certain risks in order to earn money. A trader should never trade when all odds are stacked against success. A trader should think in percentages. While a $1,000 income sounds like a nice sum of money to have, risking $5000 to get this reward is ridiculous.

Read this mindfully:

The reward should be growing relative to the growth of your potential risks. If you do not see your Forex trading portfolio evolving in accordance with this rule, something is going wrong.

When evaluating an investment, you must not think about whether the reward seems like a big sum of money. You may have a special set of standards and compare the sum to them.

There is a simple guide that consists of several consecutive steps that help you to pick the right investment. Here it is:

Select an investment idea that you think may have potential. Conduct standard research to find the size of a potential reward.

Use the chart to pick the target prices where you should take the profit or cut losses.

Use the data to calculate the reward/risk ratio.

Depending on your preferences, compare the ratio to your Forex risk management standards. If the ratio is below your goals, you should start readjusting stop losses, and take profits.

If you cannot find the right ratio for this particular investment, scrap the idea and start all over again.

After finding the right investment, you should apply other means of evaluation and decide whether you need to start working with this particular idea. The risk/reward ratio is considered by many traders a fundamental part of analysis.

This is why you should incorporate this ratio in every single decision that you make in Forex trading. A proper evaluation of the deal is what will separate you from a large number of other people.

Calculating the reward-to-risk ratio is one of many approaches for Forex trading. Discover various strategies that we have gathered for you.

Risk Management: a Practical Implementation

You should always adjust your deal according to your risk management standards regarding the reward-to-risk ratio. While you can spend time on theoretical analysis, without practical application, all your methods will be useless. You must know how to use acquired data and implement effective solutions and methods in your Forex trading routine.

The problem of many inexperienced traders is that they do not know how to set limits. Both profits and losses should be properly limited in order to achieve true efficiency in trading.

How can you use the reward-to-risk ratio to adjust your Forex risk management correctly? Use your estimations and math to set up deals with the correct stop-loss and take-profit values. Know your limits and do not be greedy.

All seasoned veterans and people who learned the intricacies of the market have one thing in common – they know how to cut losses in a timely manner. All Forex brokers will allow you to set a stop-loss order. When the deal starts going south, you will not lose more than a certain part of your trading capital that you decided to put at risk.

Look at this example:

Your Forex trading plan is focused on opening a deal on the EUR/USD currency pair and looking to earn 100 pips. Most brokers have their own spreads and commissions. Let’s say that your actual profit is about 90 pips. The potential loss is all your investment if you don’t set a stop-loss order. You can set it at 45 pips to achieve the 2/1 ratio.

One pitfall that lies in wait for all traders is that Forex markets seem like a place where the actual reward size is infinite, but it is an illusion that you should never believe.

Change Your Mindset

Various means of fundamental and technical analysis will help you to calculate probable profits but your calculations most often will mean you have to set stop-losses according to approximate estimations.

One of the good rules is to have a specific amount of money that you are willing to risk when opening a deal. This will allow you to follow the reverse analytical process.

Here is the deal:

• Set a specific limit for all of your deals.
• Calculate the minimum reward that should justify a Forex trade.
• Narrow the field of investment options to your new requirements.
• Consider a trading strategy that fits your requirements for the reward size.

This is a good practical risk management tip for anyone who wants to invest in Forex. Usually having smaller risks means more conservative slow trading. Higher risks are for aggressive trading. You should always try to be somewhere in between in order to trade more or less efficiently.

Risk and Reward as a Part of Your FX Risk Management Strategies

Calculating the reward-to-risk ratio should be your second nature. It should function like “spider-sense”. Whenever you see an investment with potential, you should immediately take your trusty calculator and start doing math. This will allow you to filter out those deals that may look interesting but have a very small reward in comparison with the risk exposure.

At the same time, some deals that have great potential to end up bringing you smaller profits can become much more efficient due to a better ratio. A trader who wants to achieve good results should develop a habit and calculate the R/R ratio constantly.

Even a rough estimation will help you to adjust various parameters of any deal correctly to make it more profitable. Developing a habit like this is a necessity for all traders. In the long run, only good ideas and proper FX risk management evaluations can help you reach your financial goals.

Another good tip is to never think of the deals you ignored due to the fact that they don’t fit your risk management requirements. Some of them will result in huge profits for someone, but they are not your missed opportunities. Those are the opportunities that you took, analyzed, and decided to stay away from.

Not jumping on the hype trains and slowly working your way toward prosperity is a strategy based on avoiding huge risks at all costs.

Be a Man of Your Word

Having good discipline is what makes a good trader (by the way, have you seen our tips on building discipline?). Start calculating the reward-to-risk ratio for every single deal that you see. Whether you want to take your chance or consider it a bad move, analyze it through the prism of the reward-to-risk ratio.

Make it into your habit and stop deviating from your effective risk management strategy. Stick to it and you will be rewarded.

Types of Forex Risks by Importance

Risks at Forex according to their importance are divided on organizational, trading and psychological types.

Organizational risks

Usually, organizational risks include the following: a right choice of the broker, a right choice of a trading account manager (trader) and the reasonable organization of the work if you trade yourself.

Each section requires detailed presentation − we will do it in the following articles, but for now, let’s note the main task for a beginner who wants to stay on the market as long as possible:

 

• Control of the reasonable leverage level

The principle of the marginal trade allows you to operate at the market with volumes much bigger than the volumes really secured by your deposit.

But be not greedy! In order to count proportionally the volume of the opened positions not only to the deposit size, but also to the level of the broker’s credit: the leverage is higher and the risk of the fast losses in case of the price movement against you is also higher.

Remember: the broker, “lending” you leverage, will never allow you to trade on credit and without the slightest hesitation will close your account when it achieves the margin call level.

 

Trading risks

For reduction of the trading losses it is necessary:

to perform the analysis of the market before you open the transaction
The analysis consists of the preliminary technical analysis (trend, price extreme, turning levels) and fundamental analysis (news, correlation of the connected assets) of the trade situation.

Only if you can accurately answer yourself why it is necessary: to buy/sell, open/close, and expose stop/to include a trailing – the transaction will bring you if not a super-profit, but a personal confidence in the correct decision.

• Compliance with the strategy and trading plan

Forex risk management depends on your trade principles and a working algorithm irrespective of whether you have developed trade system independently, have lent it, have bought from the friend or have downloaded it free in the network.

The point is:

it is necessary to stick to the trading plan rigidly under any conditions. It will facilitate the further analysis of the mistakes and will lower emotional pressure.

rigidly established admissible losses’ percent
You should carry out the regular risk control of losses for the period (day, week, month) with obligatory compliance with the critical level of losses after which any trade stops are necessary and the careful analysis of the trade actions.

1. The fixed level of the mortgage means

As a rule, the minimum level of mortgage in open transactions means no more than 1,5-3% of the deposit’s amount. Even if the current transaction seems attractive to you, don’t make investments in it more than your critical level – any price throw is capable to destroy quickly not only the current profit, but also to drain all deposit.

At a competent Forex risk management 7-10% of a deposit is considered the critical level of the pledge.

Remember: the purpose of any trade is to earn a maximum of profit not only at the minimum losses, but also by means of the minimum pledge.

2. Obligatory diversification of the transactions

Look at it this way:

The well-known paroemia about problems of investments in one basket is still relevant. In order to trade asset that most actively moves – use the high mutual correlation of the trade assets for receiving an additional profit (for example, gold and Australian dollar, the index of dollar and euro).

Remember: when opening the mutually correlating transactions it is necessary to control especially attentively a condition of the overall mortage means balance.

3. Obligatory usage of the technical methods of the loss restriction

Classical Forex risk management demands that levels of the stop orders should have been counted before an entrance. Most often it means the application of the stop for any position. But even when opening the transaction where you don’t plan to put Stop Loss at once – you have to know precisely at what price you will prefer to face a loss instead of continuing to hold the transaction.

It appeals also to the strategy in which the usage of the limit turning warrants instead of the stop warrants is planned. Using of the Stop Loss on time is also possible, if during some period some objectives about profit aren’t achieved, then the transaction will be closed at the scheduled time by stop with the minimum losses.

Remember: if you have current profit, it should be fixed partially at the possible turning levels.

Psychological risks

Psychological factors of the Forex risk management include:

• control of the trading actions

It is usually means the ability to recognize the mistakes and to stop in time. All of us can be mistaken – but losses need to be fixed in time, that is not about to “play too long” and “not to recoup”.

But here’s the problem:

the market can’t be outgamed, you have to be friends with the market and never to trade against a global trend. Of course, if only you are not Warren Buffett or U.S. FRS and don’t form this trend yourself.

Remember: the liquidity of the financial market is not limited, it means all will have enough money. Your first task is not to take away others, but not to give up yours.

• control of an emotional condition

During the trading any destabilizing emotions (fear, envy, passion, greed, panic) and the irritating factors (external noise, advices of the people around, technical problems) are inadmissible. Choose for yourself comfortable working conditions and a trading strategy with the risk level which is psychologically accepted for you: aggressive, moderate or conservative.

Remember: a trading deposit is your real money and nobody will protect them, except you.

 

Optimizing Reward-to-Risk Ratio for a Smoother Forex Trading Ride

Are you tired of riding the forex roller coaster, with its heart-pounding highs and gut-wrenching lows? Well, buckle up, because we’re about to dive into the art of taming that wild beast known as the reward-to-risk ratio. By the time we’re done, you’ll be trading like a pro, minimizing risk, and maximizing those sweet, sweet profits.

The key to optimizing the reward-to-risk ratio lies in a few nifty techniques:

Set Your Sights on the Right Trades: Not all Forex trades are created equal. Look for opportunities with a high probability of success and a favorable reward-to-risk ratio. Remember, patience is a virtue!

The Magic of Stop Loss and Take Profit Orders: Set stop-loss orders to limit potential damage from losing trades, and take-profit orders to lock in gains. These magical tools help you enhance your risk management strategies and ensure you don’t let emotions dictate your trading decisions.

Position Sizing. The Unsung Hero: Don’t put all your eggs in one basket. Adjust your trade size based on the risk-to-reward ratio and the overall risk you’re willing to take. Smaller positions for riskier trades and larger positions for safer bets are the way to go.

Diversification. The Spice of Trading Life: Spice up your trading portfolio by diversifying across various currency pairs, timeframes, and strategies. This helps spread the risk and can lead to a more stable trading performance (check out our guide on diversification).

Keep Learning and Adapting: Stay humble, Forex traders. The forex market is constantly changing, and so should your approach. Learn from your mistakes, refine your risk management strategies, and always keep an open mind.

So there you have it, fellow Forex traders! Taming the reward-to-risk ratio beast isn’t rocket science, but it does take discipline, patience, and a dash of creativity. By following these simple tips, you’ll be well on your way to a smoother, more profitable trading ride. But before conquering those Forex markets, be sure to polish your risk management in Forex Tester!

Harnessing the Power of Forex Tester Software to Master the Reward-to-Risk Ratio Game

Alright, savvy traders, now that we’ve covered some crucial techniques for optimizing your reward-to-risk ratio, let’s talk about an ace up your sleeve that can turbocharge your trading prowess: the Forex Tester software. This powerful backtesting platform is your secret weapon in honing your trading skills, refining your strategies, and becoming a true reward-to-risk ratio whisperer.

Here’s how Forex Tester can help you manage risk and more:

Practice Makes Perfect: A Risk-Free Playground

Forex Tester’s realistic market simulation allows you to practice your strategies in a safe, risk-free environment. Experiment with different techniques, analyze your performance and fine-tune your approach without risking a single penny. It’s like a Forex playground for adults!

Comprehensive Performance Analysis. Know Thyself

Forex Tester offers in-depth performance analysis, helping you identify your trading strengths and weaknesses. By understanding your trading patterns, you can make informed adjustments to minimize the number of losing trades and maximize rewards.

Real Trading Conditions: The Ultimate Test

Forex Tester replicates real trading conditions, including floating or fixed spreads, and various data accuracy options. This means you can apply proper risk management strategies under the same conditions you’ll face in the live market, ensuring you’re well-prepared for the real deal.

Custom Indicators and Algo-Trading Bots: Unleash Your Creativity

With Forex Tester, you can upload custom indicators and even create algo-trading bots without coding skills. This allows you to explore innovative strategies and manage your reward-to-risk ratio with surgical precision.

Learn and Grow with the Interactive Educational Course

Forex Tester’s comprehensive educational course provides you with the knowledge and hands-on experience needed to optimize your reward-to-risk ratio effectively. You’ll learn the intricacies of technical analysis, risk management, and trading psychology – all within the Forex Tester platform.

Forex Tester is your all-in-one solution for mastering the reward-to-risk ratio game. It’s a powerful training tool that can help you level up your trading skills, refine your strategies, and achieve long-term success in the unpredictable world of forex trading. Give it a try and watch your trading performance soar to new heights!

A Practical Example: Applying Reward-to-Risk Ratio Management with Forex Tester

Let’s dive into a practical example to see how Forex Tester can help you optimize your reward-to-risk ratio and sharpen your trading skills.

Imagine you’ve developed a trading strategy based on moving averages crossover. The basic idea is to enter a long position when the fast-moving average crosses above the slow-moving average and a short position when it crosses below. Your challenge is to manage your reward-to-risk ratio effectively while applying this strategy.

Here’s how you can use Forex Tester to achieve that:

Set Up Your Testing Environment

First, load historical data for the currency pair you’d like to trade and select the appropriate timeframe. Apply your moving averages to the chart, and you’re ready to begin!

Test Your Strategy and Identify Trade Opportunities

Start the simulation and observe the moving average crossovers. Once you spot a signal, pause the simulation and determine your entry point, stop-loss, and take-profit levels.

Calculate Your Risk-to-Reward Ratio

Based on your stop-loss and take-profit levels, calculate the risk-to-reward ratio for the trade. Remember, you’re looking for a favorable ratio to minimize risk. If the ratio is too high, consider adjusting your stop-loss and take-profit levels or waiting for a better opportunity.

Execute and Analyze Your Trades

Open your trade in Forex Tester and monitor its progress. Once the trade is closed, analyze the results and compare them to your calculated risk-to-reward ratio. Did your trade perform as expected? Were there any unexpected events that impacted the outcome? Use this information to refine your strategy and improve your risk management skills.

Rinse and Repeat

Continue testing your moving averages crossover strategy with Forex Tester, experimenting with different currency pairs, timeframes, and reward-to-risk ratios. As you gain experience, you’ll develop a better understanding of how to minimize your risk-to-reward ratio and maximize your trading profits.

By practicing this example with Forex Tester, you’ll hone your risk management skills and become a more confident, successful trader in the forex market. Happy testing, and may the reward-to-risk ratio forever be in your favor!

Final Word

Forex risk management isn’t a guarantee of a profitable trade at all, but is an obligatory component of the successful trade strategy.

In conclusion, mastering the reward-to-risk ratio game and achieving consistent success in the forex market doesn’t have to be a daunting task. With the right mindset, discipline, and the powerful Forex Tester software at your side, you can transform your trading performance and reach new heights of profitability.

So, what are you waiting for? It’s time to take charge of your trading future and unlock your full potential with Forex Tester. Empower yourself with the tools, knowledge, and hands-on experience needed to conquer the forex market and make your financial dreams a reality.

Don’t let another opportunity slip through your fingers. Invest in your success today by getting started with Forex Tester – the ultimate platform for refining your trading strategies and perfecting your risk-to-reward ratio management skills.