Trading in Financial market like Forex requires a trader to deal with an amount of uncertainty to make a specific amount of gain. Trades with higher yielding rate and less uncertainty are the ideal ones for traders. As such trades promise to yield more profit than their projected risk volume. So, a trader can find out the suitable entry simply just calculating the loss-profit volume of a trade.
How to Estimate Risk-Reward Ratio
For beginners, learning how to calculate the ratio of risk-reward with precision can be incredibly helpful. Professionals in their way to progress, learn this indispensable skill. This lesson is all about the right calculation process of loss-gain.
1. Apprehend the Importance First
Before learning anything, realizing the importance of the subject material (in this case it’s the calculation of projected loss-profit by a trade) in the context of the overall topic (in this case it’s Forex Trading). You need to know that assessing the earning and losing probability is a part of ideal money management. Without evaluating this probability, none can claim that his money management strategy is infallible and complete.
Now, even novices should have the sense to realize the underlying importance of a loss management approach. There are a plethora of examples of people who had earned an account-full of money. Then there came an opportunity with higher risk and tool all his money-making his account empty.
Newcomers should get it very clear that all UK traders are meant to balance the loss and the profit range. It is their most cardinal responsibility. To establish or maintain this balance, they should know how to estimate the Risk-reward ratio. Try to be like the top traders at Saxo Bank. Soon you will become skilled and efficient at trading.
2. Calculation Process
So, let’s dig deeper into the mechanics of calculating the ratio we are featuring. The formula is not very complicated or doesn’t require anyone more than having a basic aptitude in mathematic.
For instance, suppose one has to risk 50 pips on a deal where the targeted gain is of 100 pips. Here, the amount of effective risk/reward volume will be 1:2. Simply, he is targeting a double reward against a particular amount of losing threat.
Other than the projected risk and the expected profit volume, there are some other variables that have an impact on the ratio. Like, one should regard the spread defined for the Forex broker to manage the proper analysis. Without paying necessary attention to the spreads, investors cannot be oriented to the reasonable loss-profit estimation.
For instance, suppose that a broker charges about two pips as spread on a currency pair. Now, you have decided to risk the highest 5 units in a hope to make 10 units gain. Including that 2 units per spread you are actually estimating to lose 5+2 = 7 units to gain 10-2 = 8 units. So, the overall result deviates from the one that doesn’t involve the spread.
Now the ratio gets skewed a little, and once what was a 1:2 has turned into 7:8.
Spreads are more countable for the scalpers and day traders. As scalping and day trading are shorter timeframe business. Trades with shorter timeframe includes more spreads than the longer ones like swing and position trading. With higher chronicle-frame, the effect of the spreads gets diluted.
For instance, say one has set his stop-loss at 100 pips and target-profit at 200 pips. The straightforward version of the loss-profit ration here is 100:200, or 1:2. Now, say the broker charges 5 pips per spread. The ratio becomes 105:195, or 1:1.85. The change is not that significant, and it’s only because the losing and profiting amount are comparatively high. Such a high profit and loss amount are only set in longer timeframe deals.
So, this the most basic way to estimate the risk-reward ratio. However, you can go even deeper into that subject. You can learn about how to determine the minimum and the most affordable threat versus opportunity amount by learning more.