Risk management is one of the most important factors in your trading strategy. Learn why you should focus on selecting your position and why risk management is crucial to your trading success.

A risk: profit ratio is useful for many traders when comparing the profit sought in a trade with the amount of risk assumed to realize the profits. To calculate the risk: profit ratio, you must divide the amount you would bear to lose if the price moves in an unexpected direction (the risk) by the amount of profit sought when you close your position (the profit).

Some of the most used risk: profit ratios are 2: 1, 3: 1 and 4: 1 and this will change depending on the strategy of the operation. Clearly, there are other aspects that can influence the risk of a trade, such as money management and price volatility, but having a solid risk: profit ratio can help you manage operations correctly.

An example of a risk-profit ratio

Suppose you decide to go long on ABC stocks. He buys 100 lots, equivalent to 100 shares, which are priced at £ 20 for a total position value of £ 2,000 – due to his belief that the share price will reach £ 30. You set your stop loss at £ 15 to make sure your losses don’t exceed £ 500.

In this example, you are willing to take a loss of £ 5 per share for a target return of £ 10 per share after closing your position. Since you’ve risked half your target amount, your risk: profit ratio is 2: 1. If your profit target is £ 15 per share, your profit: risk ratio would be 3: 1, and so on.

We must remember, however, that the risk: reward ratio helps you establish your profitability, but does not give you any indication of probability.

The importance of the risk-profit ratio

A lot of traders try not to have a risk: profit ratio lower than 1: 1 because if it were lower, their potential losses would be disproportionately high before any profit. A positive risk: profit ratio such as 2: 1 indicates that your potential profit will be greater than your potential loss, which means that even if you suffer a losing trade, you will only need one winning trade to reach a net profit.

Below we have added a table to stipulate different risk ratios: profit and their impact on your total profits and losses. The table below assumes that 1 is equivalent to £ 100 and has a 50% win rate on 10 trades.

You can see in the table the potential benefits of having a positive risk: reward ratio and how this can influence your overall profit.

How much profit and loss could you make by trading Forex

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