If you boil trading down to a single question, it would be: ‘Is the potential profit worth the risk I’m taking right now?’ The risk/reward ratio (R:R) is a straightforward metric that helps you decide whether a trade is worth entering: where you’ll set your stop-loss, where you’ll take profit, and how often you need to be right for your strategy to be profitable. This ratio enforces discipline, helps you avoid impulsive trades, and builds a system that can withstand losing streaks.
Basic Concepts
Let’s look at the risk/reward ratio in simple terms:
- Risk (R) — the predetermined loss in money or pips if your stop-loss is triggered.
- Reward — the calculated potential profit if your target (take-profit) is reached.
Risk/Reward Ratio = potential profit / potential loss.
For example:
- 1:1 — risking 100 pips to gain 100 pips.
- 1:2 — risking 100 pips to gain 200 pips.
- 1:3 — risking 100 pips to gain 300 pips.
Your stop and target should be based on market logic, not just adjusted to fit a nice-looking number.
Here’s another example: Trader 1 has 75% winning trades, while Trader 2 has only 40%. Which one is more successful? We can’t answer that without knowing how much each earns on winning trades and how much they lose on losing ones. So, the percentage of profitable trades isn’t the most important factor in trading success. Of course, everyone wants most of their trades to be winners, but if you want real success in trading, you need to focus on the risk/reward ratio.
How to Use the Risk/Reward Ratio
You might assume that a 1:2 ratio is the most advantageous. If you open a trade with a risk of 25 pips, you should set your take-profit at 50 pips.
Also, try to move your stop-loss closer to your entry point once the price has moved 25 pips in your favor—that is, halfway to your target. For example, you buy at 1.2500 and set your stop-loss at 1.2475, so your risk is 25 pips.
Using a 1:2 ratio means your take-profit should now be at 1.2550, or 50 pips profit. When the price reaches 1.2525, move your stop-loss to your entry point at 1.2500. This way, you either lock in profit or break even. Once your stop-loss is at breakeven, you can look for other entry opportunities.
