Consider the old adage permeating the forex market that a trader must maintain a ratio of two dollars in potential profit for every dollar that is risked on a transaction.
Is it true? Does a 2:1 profit/loss ratio matter?
The first thing to recognize is that a successful trader is measured by profitability, not maintaining an industry-expected risk reward. Trading manuals and Forex gurus have long trumpeted the 2:1 risk reward ratio as a guidepost for traders. Traders in turn march dutifully to the mantra of 2:1 risk reward ratio.
Let's look at some examples in the forex market to test the traditional wisdom.
Trader A has a taste for risk in her trading style and accepts a healthy $400 average loss. But she is making an average of $800 on her winning trades - an "admired" 2:1 risk reward. But her winning percentage is only 30%. For every 10 trades she thus loses an average of $40, despite her 2:1 risk reward that is widely advocated.
Trader B, on the other hand, makes an average of only $175 on her winning currency trades but still endures a $400 average loss - a frowned-upon risk reward on 1:2.29. Yet she makes a gain on 70% of her trades. For every ten trades she makes she realizes a profit of $25.
What is at work here is not the risk reward ratio that is determining profitability but the risk reward ratio operating in tandem with winning percentage. It is the expected win percentage AND the fundamentals of the risk reward ratio that must be continually evaluated.
When playing the forex market traders must determine the style of trader they are, not blindly pursue industry-recommended ratios. Once a calculation is derived to tag your win percentage as a trader, then you can figure what risk reward ratio is needed at a minimum to make a trade pay off.
Traders with lower win rates must make sure their trades average larger risk rewards to deliver bottom line profitability. Others who are not willing to take large hits for a big score will push their trading activities towards a higher win rate and smaller risk reward ratios.
Too often trades are labeled a good play if they present rewards two and three times the money risked. But what if the trade has a success rate of only 10%? Who is going to make that "good" trade now? On the other hand if your research shows a statistical edge that provides a 90% win probability what will it matter if you are trading with a 2:1 risk reward or a 1:5 risk reward? Trading in the forex market can't be executed in knee-jerk fashion based on accepted ratios born in an informational vacuum.
There are many roads to success in the forex market but one road is pitted with more potholes than the rest - following traditional wisdom.
Is it true? Does a 2:1 profit/loss ratio matter?
The first thing to recognize is that a successful trader is measured by profitability, not maintaining an industry-expected risk reward. Trading manuals and Forex gurus have long trumpeted the 2:1 risk reward ratio as a guidepost for traders. Traders in turn march dutifully to the mantra of 2:1 risk reward ratio.
Let's look at some examples in the forex market to test the traditional wisdom.
Trader A has a taste for risk in her trading style and accepts a healthy $400 average loss. But she is making an average of $800 on her winning trades - an "admired" 2:1 risk reward. But her winning percentage is only 30%. For every 10 trades she thus loses an average of $40, despite her 2:1 risk reward that is widely advocated.
Trader B, on the other hand, makes an average of only $175 on her winning currency trades but still endures a $400 average loss - a frowned-upon risk reward on 1:2.29. Yet she makes a gain on 70% of her trades. For every ten trades she makes she realizes a profit of $25.
What is at work here is not the risk reward ratio that is determining profitability but the risk reward ratio operating in tandem with winning percentage. It is the expected win percentage AND the fundamentals of the risk reward ratio that must be continually evaluated.
When playing the forex market traders must determine the style of trader they are, not blindly pursue industry-recommended ratios. Once a calculation is derived to tag your win percentage as a trader, then you can figure what risk reward ratio is needed at a minimum to make a trade pay off.
Traders with lower win rates must make sure their trades average larger risk rewards to deliver bottom line profitability. Others who are not willing to take large hits for a big score will push their trading activities towards a higher win rate and smaller risk reward ratios.
Too often trades are labeled a good play if they present rewards two and three times the money risked. But what if the trade has a success rate of only 10%? Who is going to make that "good" trade now? On the other hand if your research shows a statistical edge that provides a 90% win probability what will it matter if you are trading with a 2:1 risk reward or a 1:5 risk reward? Trading in the forex market can't be executed in knee-jerk fashion based on accepted ratios born in an informational vacuum.
There are many roads to success in the forex market but one road is pitted with more potholes than the rest - following traditional wisdom.
Editors’ Picks
EUR/USD strives to gain ground near 1.1770 on improving dovish Fed prospects
The EUR/USD pair attempts to regain ground near 1.1770 during the Asian trading session on Friday. The major currency pair attracts slight bids as the US Dollar ticks down amid an improvement in speculation that the Federal Reserve could cut interest rates in the March policy meeting.
GBP/USD drops to two-week low, around 1.3500
The GBP/USD pair adds to the previous day's dovish Bank of England-inspired heavy losses and drifts lower for the third straight day on Friday. The downward trajectory is sponsored by sustained US Dollar buying and drags spot prices to a two-week low during the Asian session, with bears now awaiting a break below the 1.3500 psychological mark before placing fresh bets.
USD/JPY drops back below 157.00, as focus shifts to Japan snap election
USD/JPY is back in the red below 157.00 in the Asian session on Friday. The Japanese Yen recovers ground against the US Dollar amid some profit-taking ahead of Japan's snap general election on Sunday. The preliminary reading of the Michigan Consumer Sentiment Index report for February will be released later on Friday.
Editors’ Picks
AUD/USD bounces back toward 0.6950 after RBA Bullock's comments
AUD/USD is seeing a sharp turnaround toward 0.6950 in the Asian session on Friday, following the hawkish commentary from RBA Governor Michele Bullock. A pause in the US Dollar advance also underpins the Aussie's recovery. However, the further upside appears limited amid a risk-off market environment.
Gold dip buyers emerge once again near $4,650
Gold bounces off $4,650 demand area yet again amid broad risk aversion. The US Dollar retreats from ten-day highs as buyers take a breather after the recent uptrend. Technically, Gold’s bullish trend remains intact, with dip-buying a key trading strategy.
USD/JPY drops back below 157.00, as focus shifts to Japan snap election
USD/JPY is back in the red below 157.00 in the Asian session on Friday. The Japanese Yen recovers ground against the US Dollar amid some profit-taking ahead of Japan's snap general election on Sunday. The preliminary reading of the Michigan Consumer Sentiment Index report for February will be released later on Friday.
Bitcoin, Ethereum and Ripple sink to multi-month lows
Bitcoin, Ethereum and Ripple slip to multi-month lows, erasing all gains since crypto-friendly candidate Donald Trump won the US presidential election in November 2024. BTC hits a low of $60,000 on Friday, while ETH nosedives to $1,750 and XRP to $1.11.
The AI mirror just turned on tech and nobody likes the reflection
Tech just got hit with a different kind of selloff. Not the usual rates tantrum, not a recession whisper, not even an earnings miss in the classic sense. This was the market staring into an AI mirror and recoiling at its reflection.
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