Risk/reward ratio

The general theory is that if the risk is greater than the reward, the trade will not be worth it. A good risk/reward ratio could be seen as greater than 1:3, where you would risk 1/4 of the overall potential profit. For trading to prove profitable in the long term, a trader should not typically risk their capital for a lower risk/reward ratio, as this will mean that half or more of their investment could be lost. When trading with leverage​​, these losses will be magnified.

However, it is not that simple, and the risk/reward ratio that a trader adopts depends on their trading experience, style and strategy. Advanced traders will often use a lower risk reward ratio, such as 1:1 or 1:2, in the hope of the risk paying off.

The forex market makes for a good example when calculating the risk/reward ratio. When trading currency pairs​, the smallest price movement is referred to as a pip​ (percentage in point) and these pips move up and down when a currency’s value strengthens or weakens.

Lets’ say that you open a spread betting position to trade on EUR/USD, which is perhaps the most popular major forex pair to trade. You take a stance on whether the currency pair will rise or fall in price. If you set a profit target of 100 pips and risk 50 pips, this equals a risk/reward ratio of 1:2. This is because, for every 50 pips you risk, you have the chance earn back a profit of double the amount. However, remember that you will need to take into account charges such as spreads and transaction costs, so this profit would be reduced slightly.

Economic strength and stability, as well as instability, can have an effect on a currency pair’s price. In times of economic hardship, a country’s national currency can crash and weaken against the secondary or quote currency of the currency pair. This is when traders should take extra caution when trading in the forex market​​, as currencies can depreciate in value at a rapid pace.

The share market​ is one of the most popular and liquid financial markets to trade after forex. For this reason, it comes with many risks and rewards. The stock market is made up of penny, micro-cap, small, medium and large-cap stocks, as well as blue-chips​, which set the benchmark for their industry. Different types of stocks produce different risk/reward ratios.

Similar to forex trading, the share market is equally affected by fundamental factors. Economic indicators such as news releases, earnings reports and a country’s economic stability can cause a company’s share price to plunge. Alternatively, a company’s stock price can soar after a positive earnings report. This leads to what is called a short squeeze​​, when traders all scramble at once to buy the company’s stock, leading short sellers to exit their trades as quickly as possible. This can be equally damaging to investors as a fall in share price.

Trading stocks can produce volatile results, therefore, it is necessary to stress the importance of risk management when entering a market that you are unfamiliar with. Risk/reward ratios should be thoroughly considered before placing a bet.

As shown in the chart at the start of the article, some financial investments come with a much higher risk than others. This includes futures and options, and these often work well within volatile markets such as commodities trading. Taking a chance on high risk high reward stocks, such as small-cap or penny stocks, can also pay off in the long-term if they show consistent earnings, balance sheets and cash flows in the long-term. Some of these stocks may obviously dissolve within their early days, while some may turn into the next blue-chip stocks. Trading emerging markets works in a similar way to these equities, either through exchange-traded funds​​ (ETFs) or initial public offerings (IPOs).

We also host the international trading platform, MetaTrader 4, which is known for its endless range of indicators and add-ons that are created by users of the platform. Trading with MT4 includes an algorithmic system for faster and more seamless execution, which is important when trading in volatile and risky markets. Many users have already created risk/reward indicators for the MT4 software, which help to calculate the ratios automatically as traders decide where to enter and exit a position. Learn more about the MT4 platform or get started by now registering for an account.