Monday, July 11, 2016

What is a Risk/Reward Ratio

You probably might have heard this terminology several times while reading some educational trading blogs, but maybe you’re still left asking what ‘Risk/Reward ratio’ is, and why is it important to understand what it is. Don’t worry, it’s the purpose of this article to discuss with you what a risk/reward ratio is. 

One of the reason why most traders end up losing money in trading is because they fail to manage their risks. Most investors don’t appreciate or have no idea about the significance of risk management and risk/reward ratio, so they fail to include these measures in their trading strategies.

A Risk/Reward ratio is a common term used in the financial markets to compare the amount of the expected profit from the investment to the amount of risk undertaken to earn these profits. To make it more simple, investing your hard-earned money in trading is pretty risky, and if you’re going to risk your cash, it is just right to expect a reasonable amount of potential returns.

For example, if somebody asks to borrow $30 from you and offers to pay you $45 in two weeks, you might think that it’s not worth the risk. But, what if someone asks to borrow the same amount and offers to pay $60 in return? The risk of losing $30 to potentially earn $60 in return might now sound appealing to you.

The most common mistake traders make is they use a negative Risk/Reward ratio, wherein the amount of risk exceeds the amount of reward. Negative risk/reward ratio puts you in an unfavorable position as it needs a much higher winning percentage in order to make up for the losses and be seen as profitable. 

A risk / reward ratio is a measure of the amount of profit you expect to earn in a trade, relative to what you are risking in the event of a loss. Familiarizing yourself with this ratio allows you to manage risk by setting expectations for the outcome of a trade prior to entry. The trick here is to set a positive ratio for your strategy. This way, you can increase the margin of profit during winning trades, relative to the amount you lose during losing trades.

However, you should not rely on this strategy alone if you want to be successful in trading. You should continue studying and reading educational forex articles to know which strategies you should include in your current trading plan.

Learn more about forex trading by regularly reading the articles posted on our educational forex blogs. See who the best forex brokers are, visit to find out!

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