When using appropriate trading risk management techniques, an especially useful technique to use to assess the quality of a particular trading opportunity involves calculating the risk to reward ratio of each potential trade.

Since most personal forex traders have a limited amount of capital to trade with, doing so allows you to choose trades that have a higher amount of potential returns or profits for a given amount of risk assumed in taking the trade.

How Risk Reward Ratios are Calculated

You can calculate your risk on any given trade by determining how much you think you might possibly lose on a trade. For most forex traders, this is simply the difference between their entry point and the level of their stop loss order multiplied by their proposed position size.

When it comes to assessing potential rewards, you would look at the number of pips between your entry level and your take profit level or levels, multiplied by your contemplated position size, to obtain your potential return.

By then looking at the ratio between risk and reward on a trade, you can then apply a trade selection standard, such as only taking trades with risk reward ratios better than 1:2, for example. This means that you might consider trades that risk just 100 pips to make 200 pips or more.

A refinement to this risk/reward analysis would involve assessing the probability of achieving the potential profits versus taking the potential losses and multiplying it by the appropriate quantity to obtain a probability-weighted risk/reward analysis.

For example, you might contemplate a trade which has 100 pips of potential profits and 100 pips of potential losses if your analysis determined that the profits were twice as likely as the losses.

Naturally, a major problem arises with using this type of probability weighting when you do not have an objective means of determining the necessary probabilities.

Risk Reward Ratios and Position Sizing

A successful forex trader typically knows not only the risk reward on any given position, but what percentage of the account is at risk on any given trade. An accepted size for an individual position in a forex account puts no more than 2% at risk on any given forex position.

The amount of risk that a trader assumes on any given position can be immediately assessed with the size of the positions in relation to the size of the account.

Typically, most experienced traders look for risk reward ratios of at least 1:3. Many traders prefer even larger risk reward ratios and patiently wait until they can get into a position with a 1:5 ratio or more.

The Importance of Managing Risk

Without a clear concept of risk, a trader can easily take on more risk than they can handle which eventually leads to cleaning the trader out of their money and the trader going back to their day job.

Building an account gradually and increasing the trading units as the size of the account increases makes the most sense. Nevertheless, many novices begin trading without assessing their risk and without sizing their positions according to sound money management principles.

Remember that trading in the forex market has a very high risk factor, regardless of what you may have heard. Trading in the forex market is a serious business if you value your money, so it makes sense to treat it that way by having a sound trading plan that incorporates good risk management practices.

Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.