Understanding risk and reward
Controlling your risk amount per trade
If you haven’t yet watched the video at the beginning of this course, we recommend you do so before continuing with this lesson.
It’s possible to be wrong more times than you’re right, yet be consistently profitable. It’s all down to risk vs reward.
To calculate the ratio on a particular trade, simply compare the amount of money you’re risking to the potential gain. So, if your maximum potential loss on a trade is $200 and the maximum potential gain is $600, then the risk vs reward ratio is 1:3.
Example
Consider the following: if you’re flipping a coin and are trying to guess the result, you have a 50% chance of predicting the outcome correctly.
If you lose $1 when you're wrong and make $1 when you're right, you're moving towards breaking even. But as a trader, you also need to account for costs like spreads, slippage or commissions. So even if you’re correct 50% of the time, you'll probably lose money over the long term.
Because it’s impossible to guess correctly every time, the best way to remedy this is to win more when you're right than you lose when you're wrong. This is known as a 'positive' risk vs reward ratio.
Returning to our coin-flip analogy, now imagine you lose £1 when you're wrong but make £2 when you're right. This would be a 1:2 risk vs reward ratio.
If you're right 50% of the time, the extra profit you make will more than offset what you lose when you're wrong.
If, for example, you placed ten trades with this ratio and you were successful on just three of those trades, your profit and loss figures might look like this:
You could’ve made $400 over ten trades, despite only being right 30% of the time. That’s why many traders like to stick to a risk/reward ratio of 1:3 or better.
If you’re a high-frequency forex trader making over a hundred transactions per day, then even 2% per trade could be far too high. It all depends on you and how you like to trade.
A word of warning, though: if you’re taking on less risk for a greater potential reward, it’s likely that the market will have to move further in your favour to reach your maximum profit than it will to hit your maximum loss.
So, in the above example, the market would probably have to move three times as far in your favour to reach a $600 profit than it would have to move against you to cause a $200 loss. However, you should be aware that if you place your stop too close to the market’s value when you open your position, you risk automatically closing the trade too quickly – you may potentially miss out on profits should the market turn around in your favour.
With a live IG trading account, you can use our trade analytics tool to help you see the risk-reward ratio of your trades.
Lesson summary
- The potential profit on a trade should outweigh the risk to your capital
- Your goal should be to gain more if you’re right than you might lose if you’re wrong
- It’s advisable to stick to a risk-reward ratio of 1:3 or better
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