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How risk is measured relative to reward

When we talk about risk and rewards they are both very strongly intertwined. The higher the risk, the more likely it is you will get notable rewards. But there is also a chance that you will lose more money.

It concerns not only money but other subjects as well. In sports for example, if you risk playing more in attack the chances you will score more goals are significantly higher. On the other hand, you are more vulnerable to conceding a lot of goals.

Speaking from a financial perspective risk and reward interdependence are prevalent in trading and especially in Forex. In this article, we will talk about how risk is measured relative to reward.

Risk and profitability in Forex

Risk and profitability in financial markets are very closely linked, so if you prefer low risks, then you should be prepared and proportionately low returns. One of the lowest-risk assets are bonds of states whose default is unlikely (The US, Great Britain, Germany, Japan, Australia, etc.). 

It is the low yield of “safe assets” that leads traders to Forex. With high leverage in the foreign exchange market, you can earn 10%, and even 50% (at least, in the best moments). However, do not be deceived: for a huge potential profit, you have to pay a huge risk. It is a part of financial trading basics a beginner must know when he or she is stepping into the foreign exchange market.

The yield on Forex is determined by the trader’s strategies and his capital management skills. Since there is no external data on profitability, it is worth starting with a risk-to-earnings ratio adequate to your strategy or system. Some claim a 5:1 ratio, but it can only be achieved at short intervals. The ratio of 3:1 or 2:1 looks more plausible in the long distance. At a ratio of 3:1 for each dollar lost, the trader receives three in the form of profit. So even if out of 25 trades 18 (72%) will be unprofitable, the trader will still not be at a loss. With a ratio of 2:1, it will be possible to lose no more than 9 trades out of 25 (36%) to at least a little stay in profit.

It should be noted that risk/reward ratios in Forex, as well as risk management, play a focal role in trading. Ignoring them often causes a lot of complications for traders.

Many trading gurus always tell beginners that the strategy can allow for more losing trades than winning trades, and at the same time be quite successful. Mathematically, this is absolutely true, but from a psychological point of view, this approach can be a problem for many.

The arithmetic component of the risk-earnings ratio is also the reason that experienced traders are not advised to look for any ideal indicators. The ideal, first of all, should be an understanding of the ratio of risk and profit. Once you realize that this value is in many ways decisive, you will immediately get rid of nervousness in trading and will clearly follow the original system.

Profit-loss ratio

With the ratio of profit and loss, everything is simple: for example, if for a certain period the trader earned 1000 dollars, and lost 500, the ratio of profit and losses was 2:1. The risk-earnings ratio is a little different: it’s about how much the trader is willing to lose (e.g. the same $500) to get 1000. Yes, in this case, the ratio will also be 2:1.

The problem is that many people think it’s the same thing, but it’s not always the case. In order to understand the difference, you first need to understand in detail the ratio of profits and losses – not with the supposed, but with the real. This requires calculating total profits and losses on all transactions over the past few months. If you haven’t started trading yet, you should apply the chosen system to historical data. Next, you need to divide the number of profitable trades by the amount of unprofitable. Let’s say you got 2:1, i.e. for every 2 dollars won, there is 1 dollar of loss.

Not bad, but it doesn’t give us much. The profit-to-loss ratio says nothing about the amount of capital you are risking and the expectations for the next transaction. After all, it could be that for a whole year, having an account of 10,000 dollars, you got a profit of 200 and a loss of 100, having concluded only 2 trades. The ratio remained the same, 2:1, but the return on capital will be extremely low, and the ratio of risk and profit from such statistics also does not get. In theory, it should also be 2:1, but how much could be risked in one transaction? It’s not known. If there were 5 trades with a profit of 40 dollars, then it would be clear that to obtain a 2:1 ratio the risk for each transaction would have to be $20.

Conclusion

To sum up, we should note that nothing in life comes without risks – especially if we are talking about Forex trading. Yes, you can earn some money with lower risks but once again the great profits come with big risks. Sometimes you just have to rely on intuition and make sensible decisions.

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