The risk/reward ratio measures the potential reward an investor can earn for every dollar they invest in an investment, based on the amount of risk they are willing to undertake. Investors compare the expected returns with the level of risk to determine the ideal ratio. A lower risk/reward ratio implies a lower risk for an equivalent potential gain. Traders use this approach to determine the best trades to take. The ratio is calculated by dividing the possible loss by the expected profit.
Traders can connect their MT4 accounts to dedicated result-tracking websites such as Myfxbook. After connecting their portfolios, traders can easily monitor and analyze their risk/reward ratio to make informed trading decisions. Nowadays, forex brokers such as HFM offer suitable educational materials so that traders can get better consistency by adjusting their profit factor and win rate.
How can I calculate risk: reward ratio?
To calculate your risk-reward ratio, simply divide the amount you could earn (reward) by the amount you stand to lose (risk). For instance, if you purchase a stock for $1000 and plan to sell it at $5000, your reward would be $5000. If you are willing to risk your entire investment of $1000, then your risk is also $1000.
The risk-reward ratio, in this case, would be 1-to-1, indicating that the risk and reward are equal. However, if you employ a stop-loss strategy to minimize your risk, such as setting a stop-loss order at $500, your risk would now be $500. If your expected profit of $5000 remains the same, your reward would still be $5000, thus resulting in a risk-reward ratio of 1-to-10.
Your Exit Points
How you enter and exit a trade determines your profit factor, similar to your winning ratio. The profit factor is calculated by dividing the stop loss and take profit pips. The take profit and stop loss levels for a trade determine the probability needed for the trade to be successful.
Profit factor or risk: reward ratio
Table 1. The required win rate to stay profitable with a particular risk: reward ratio. Notice how the profit factor decreases with the increased win rate.
To better understand the idea, consider a scenario where a trader purchases 100 Microsoft stocks for $1000 per share. He decides to set a stop loss at $999 and a take profit level at $1002. In this case, the trader’s profit factor is two, and he only needs to win one-third (33.3%) of the time to break even. Some institutional traders have vast experience that they can profit even with low-profit factors, provided they have a high win rate.
Some Important Formulas to Note
Total net profit = gross profit – gross loss
The formula calculates total net profit by subtracting gross losses from gross profits. However, this formula alone may not be sufficient to assess the performance of a trading system.
Profit factor = (Gross profit)/(Gross loss)
The profit factor formula calculates the ratio of gross profit to gross loss and can be used to determine the win rate needed to remain profitable.
Percentage profitability = (Winning trades)/(Total trades) or Minimum win rate = 1/(1+risk:reward)
Percentage profitability is calculated by dividing the number of winning trades by the total number of trades. In contrast, the minimum win rate is calculated as 1 divided by the risk-to-reward ratio.
Total net profit = (Total net profit)/(Total trades)
Finally, total net profit can be calculated by dividing the final sum of profits, including losses and commissions, by the total number of trades. These formulas help traders make informed decisions about their portfolio and risk management strategies.
How can I improve my win rate and risk: reward ratio?
Learning about risk management is important if you want to improve your trading skills. It’s crucial to keep in mind that you should only risk the amount of money that you can afford to lose. Here are further tips to help you:
Limiting your risk to 1-2% of your account balance is another important tip to follow.
Tracking the performance of your portfolio using websites like Myfxbook is recommended.
Always set proper stop loss and take profit levels when entering a position. Avoid changing these levels during a trade.
If a trade moves in your favor, moving your stop loss to breakeven is a good idea, though this might vary depending on your strategy and trading style.
Understanding and managing risk is essential for any successful trader. The risk/reward ratio and win rate are important metrics that can help traders make informed decisions about their portfolio and risk management strategies. By tracking their performance, setting proper stop loss and take profit levels, and limiting their risk to 1-2% of their account balance, traders can improve their win rate and risk: reward ratio.
It’s important to remember that trading involves a certain level of risk, and traders should only risk the amount of money they can afford to lose. By following these tips and utilizing the formulas provided, traders can improve their trading skills and increase their chances of market success.