Risk/Reward Ratio – An Effective Tool to Size a Position

Risk/Reward Ratio – An Effective Tool to Size a Position

Submitted by adil on Fri, 11/14/2014 - 08:22

In a position sizing, traders take important decisions about trading positions as it helps them design a reasonable trading strategy. It is one of the most crucial elements of money management strategy. A trader must evaluate the risk and reward ratio regularly for the trades he plans to enter in, and make it a part of their trading strategy. Moreover, this ratio can also be applied for sizing a position based on how profitable a prospective trade would be.

How to Define a Risk and Reward Ratio

Calculate the estimated risk of the trade you wishes you enter into, and compare it with the calculated expected return that you can generate from that trade. For that to happen, simply compute the pips starting from the entry rate till the stop loss point, and then compare it with the pips of expected profit level. Having a ratio of 1:2 shows that you are willing to risk 1 pips of loss, for earning two pips of profit.

An experienced trader never enters a trade unless he or she is sure that the risk associated with that trade is half the size of expected return. An effective money management strategy involves taking low risk as compared to the expected return when you are trading in the forex market.

When to Use Risk and Reward Ratio

This ratio is usually used to estimate how large the trading position should be. Along with the ratio analysis, traders also consider some factors of technical analysis, such as, resistance and support level. As already discussed, an experienced trade never trade unless the profit is double the size of the risk. However, if high profits are expected in the future, a trader may take on larger trades with the help of risk and reward ratio.

Position Sizing with Risk and Reward Ratio

Position sizing can be done in various ways and one way to do it is to use risk and reward based approach. With that approach, a trader would go for larger positions if the prospective trade seems profitable, and the risk is maintained at an acceptable level.

For a successful position sizing using the risk and reward ratio, calculate the ratio and take a position only if it is better than a benchmark ratio used by traders, i.e., 1:2. This way, a trader would be taking a trading position based on how profitable a trade would be. He can also take 2 lot positions in case of 1:2, and may also take 3 lot positions if the ratio is 1:3 and so on.

Risk and Reward Ratio – A Step by Step Approach for a Successful Forex Trading Business

An advanced form of risk and reward ratio analysis can be performed if you want to evaluate a business risk involves in forex trading. This involves a step by step approach and it is as follows:

Do Research and Find Potential Risks – Conduct a detail research regarding forex trading business in order to forecast the expected risk that you can face while trading in the market.

Assess the Expected Profits and Losses – Calculate the potential profits that you can generate from the trade and the associated risk of loss that is expected to occur, and then compare them with each other in order to have a rough profit and loss figure that will be helpful in taking trading decisions.

A successful and experienced trader is always aware of the risk and reward ratio of the trading positions. Being a trader, you should understand that forex market is highly volatile and therefore, involves a high degree of risk. Therefore, if you want to be successful in forex trading, it is important for you to add effective risk management strategies in your trading plan to increase the value of your investment.