Risk against rewards is the very basis of any investment, it is also what keeps traders from being irrational and throw away large amount of money on a gamble that may not pay off. FOREX traders have long maintained that a positive risk- reward ratio is the key to bringing in profits in the long term in a consistent and steady manner.
While a skill for spotting a good setup, and making use of it can be developed over a long period of time, it does not mean that new players to the market cannot do it. The risk to reward ratio is something that has been setup as something of a platform on which both types of traders, experts and novices have an equal chance of making money, consistently.
A good understanding of risk to reward ratios and how to implement them in making trade setups is one of the most important things that any trader will have to know and develop. Possible risk to possible reward- The holy grail of FOREX trading.
There is no right
Before getting into anything else, consider a plain and simple fact: there is no one formula or magic number in the risk to reward ratio. Many traders, and you may have come across some of them, who are in the pursuit for the right ratio and they operate under the assumption that they are always wrong and are yet to find the ratio. That is why many traders keep on adjusting their entries even at the last minute. What they fail to realize is that a tight stop loss by itself means you are careful about your entry level. The trick is to have a wide stop loss and still make a trade with a positive risk to reward ratio.
Wide stop loss and how it works
It may seem completely out of place or just plain reckless to have a stop loss margin that is relatively wide, but if you make the setup well, you can easily make a good return with a high success rate.
Here is an example of how this works, using a long term trade on the EURUSD. The intention is to get 1000 pips on 300 pip stop loss. The risk to reward ratio in this setup will be 3.3:1 and can be converted into one which will eventually yield 15 times the risk or more, which will make the risk to reward ratio 15:1, immensely positive.
Entry is everything
To begin, you will need a strong entry as if your entry point is good, it naturally boosts your rate of success and the risk to reward ratio with it. Optionally, a catalyst, one that can trigger the trade will also be useful.
When the entry level is reached and the signal is given, go in as always, but just keep the stop loss far away, double it. Once the market begins to give way, move to an additional position, after it has gone about 150 pips, wait for another point of entry. When that is done, combine both of the stops and move them simultaneously so that you are not risking more than you have to as planned originally. Because you are also making profits from the first entry, your position can stay wide, which by now will be twice as big. If you now set a fresh target of, say 1000 pips on the second position, your risk remains constant, but your risk to reward ratio is 6.6:1 now.
By this method, every time a good entry is maximized, you will, reduce risk and build on reward.