Risk-Reward and Why it is so Important

Filed under: Learn Forex Trading |

For today’s forex-related article, I would like to take you through the whole issue of risk-reward scenarios and why it is so instrumental in whether you are profitable or not. There are several key ingredients to trading forex: these being having a sound methodology, using good methods of money management, and using a positive risk-reward setup. All of these things must work with each other; otherwise, you may start to carry some big losses.

 

Once you have a good methodology and you know about good money management, you must become converted to the benefits of having a positive risk-reward scenario. Let me briefly take you through some of the rudimentary mathematics of this.

 

You may think you are doing pretty well if 60% of your trades are profitable. Just supposing that you had a negative risk-reward setup when you did this, and you were risking 2% of your bank to make a 1% profit (a risk-reward setup of 2:1). How would this pan out? Well, after one hundred trades, on average, you would be carrying a loss of 20% on your bank. After 500 trades, your bank would be completely wiped out – even though 60% of your trades were successful.

 

Now, let’s suppose that you have a risk-reward setup of 1:2 (you risk 1% of your bank for a 2% reward) and this time, only 40% of your trades are successful. What does this mean? Well, after 100 trades, your bank would have risen by 20%, and after 500 trades your bank would have doubled! That is the power of having a positive risk-reward setup. Ignore it at your peril.

 

So it just goes to show how powerful and important having a positive risk-reward setup can be when you are trading forex. Even if you have a sound methodology and exercise good money management skills, having a negative risk-reward scenario can lead to your bank being completely wiped out.

 

 

*Personally, I always have a risk-reward setup of at least 1:2, and sometimes I go for anything up to five or six times my risk (although not as often).

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