Measuring Risk vs. Reward When Trading Forex
When it comes to trading on the Foreign Exchange market one of the most important factors to keep in mind is the Risk-Reward ratio. The Risk-Reward ratio measures the potential risk against the potential reward in a particular trade and can help you to determine whether the trade is worth it.
The “risk” in the Risk-Reward ratio is equal to the amount of money that you will need to enter the trade. For instance, if you will have to spend $100 to enter the trade then you are risking $100. The “reward” is the amount of money that you are hoping to gain in your trade when the currency rates rise or fall in your favor.
Let’s say, for example, that you are risking $100 in the hopes of earning a reward of $400. In this case the Risk-Reward ratio can be described as 100:400, or 1:4. A good ratio is one in which not much has to be risked in order to reap a large reward. For instance, this 1:4 ratio is a better trade then a 1:2 ratio in which $100 is invested in the hopes of earning a reward of $200.
So how can you decide whether to trade or not based on the Reward-Risk ratio? A good rule of thumb is that the bigger the ratio the better. Never trade on 1:1 ratios and certainly don’t make trades in which the risk is bigger than the potential reward if you are after a successful trade.
