Risk-reward ratio - the number one reason for foreign exchange trading losses

Traders should manage risk every time they trade. In this article, we will explore how to use risk and reward to trade.

When traders trade, they usually carefully study the chart and plan the opening point. Most traders focus on more accurate timing of opening positions, which is actually a misunderstanding in trading. Risk management is what traders should study more immediately. Good risk management can help traders establish a comprehensive trading plan and get out of the market in time when the market trend is unfavorable. Below we will introduce how to manage risk in trading through risk reward.

USD/CHF 4-hour chart

Risk-reward ratio refers to the ratio of the number of points we expect to make a profit on a trade (take profit) to the number of points we expect to lose (stop loss). Knowing this allows traders to better manage risk by precisely locating the take profit level. The key to using risk-reward ratio is to find good ratios and strictly enforce them on every trade. Let's try to illustrate with an example.

Above is a 4-hour chart of USD/CHF. We can see that the exchange rate forms a trading channel, and traders looking for an entry can enter the market long when the exchange rate rebounds from the lower support line, in this example the price is 0.9580. When trading a channel, traders should place their stop loss below the channel support (as opposed to above the channel resistance when shorting), in this case we set our stop loss to 0.9465. If the price falls below this level, our loss is 115 basis points. So if we want to establish a good risk-reward ratio, say 1:2, then our profit target needs at least 230 basis points, in this case 0.9810 (0.9580 + 230 = 0.9810). We will explain the importance of doing so below.

Traders who are concerned about risk and reward will not let goforeign exchange marketThe number one mistake traders make. The chart above is the data analyzed by FXCM. The blue line represents the average profit basis point per trade of traders in the foreign exchange market, and the red line represents the average loss basis point. Surprisingly, although most traders have a high trading success rate, with more profit position squaring than loss position squaring, it still does not change the fact that the overall loss. The reason is that these traders do not pay attention to the importance of risk and return. In the chart above, we can see that in the USD/CHF trade, traders made an average profit of 44 basis points per trade, but lost an average of 90 basis points. Even if a trader's trading success rate is high, in the case of losing more and winning less, the trader still cannot get rid of the overall loss situation.

This situation can be completely avoided by using risk-reward. Setting a risk-reward ratio of 1:2 allows you to win more when you are profitable and stop losses when you are losing. This way, we only need to make a profit once to offset the loss caused by two losses. Keeping an eye on risk-reward will make a big difference in your trading results in the long run.