How to Calculate the Risk:Reward Ratio of a Trade
The risk:reward ratio compares the potential loss to the potential gain of a trade, typically measured in pips. Knowing this helps to assess if the potential reward justifies the potential risk.
How to Determine the Potential Risk
Firstly, we need to determine our risk. This should be the maximum loss of the trade, and there’s a really easy way to determine this: the amount of pips from the entry to where the stop loss is placed. Using the stop loss is the most logical option, as that’s going to be the maximum loss on the trade.
Taking a look at the following screenshot, we might place the stop loss based on a break of the previous swing low. In our example, this is 10 pips away.
How to Determine the Potential Reward
The potential reward can be a little more tricky. We need to identify the target, we call this the trade move potential. Many traders will base the reward as the ultimate target of the trade, but this isn’t the right thing to do.
Instead, it should be based on a realistic target. A point where the price could turn against you, even if you think it may go further. This keeps our risk:reward ratios realistic and keeps our estimates grounded in reality.
Referring back to the previous screenshot, we may decide to place our trade move potential 30 pips away based on the previous lower high. That doesn’t mean we’ll close the trade here, it’s just the minimum we’d expect from that opportunity. Like with the risk, we measure the distance from the entry to the target in pips.
Calculating the Risk:Reward
Now we have the two distances we need to calculate our risk:reward ratio.
If the risk is 10 pips, and the reward is 30 pips, that gives us a 1:3 risk:reward ratio. We now know for every $1 at risk, the potential reward is $3.
This is only two thirds of the equation to determine profitable opportunities though. The equation I’m talking about is the traders equation which is a combination of:
- The average size of your losses (Risk)
- The average size of your profits (Reward)
- Your success rate (how many of your trades are profitable).
That means the next step for you is to know the success rate, otherwise known as the probability of the opportunity.