What is risk and reward in trading?
There is an increased chance of losing money when trading in high-risk markets, including commodities and forex. This is because these markets are highly liquid and volatile, and are affected by a number of internal and external factors, including economic indicators. Other derivative products, such as futures, forwards and options, are also a risky investment, along with certain types of stocks and exchange-traded fund investments.
Certain trading strategies are also considered high risk in comparison with others. Short-term strategies such as scalping and day trading aim to make small but frequent profits from price fluctuations in volatile markets, by entering and exiting the position as quick as possible. These strategies can pay off if successful but there is an equal risk of losing a large amount of money.
What is a good risk/reward ratio?
The general theory is that if the risk is greater than the reward, the trade will not be worth it. A good risk/reward ratio could be seen as greater than 1:3, where you would risk 1/4 of the overall potential profit. For trading to prove profitable in the long term, a trader should not typically risk their capital for a lower risk/reward ratio, as this will mean that half or more of their investment could be lost. When trading with leverage, these losses will be magnified.
However, it is not that simple, and the risk/reward ratio that a trader adopts depends on their trading experience, style and strategy. Advanced traders will often use a lower risk reward ratio, such as 1:1 or 1:2, in the hope of the risk paying off.
1 to 1 risk/reward ratio
This ratio is usually put into practise by more experienced or daring traders, who are willing to risk a higher percentage of capital for a higher potential profit. A risk/reward ratio of 1:1 means that an investor is willing to risk the same amount of capital that they deposit into a position. This can go in two directions: either the trader will double their amount of capital through a winning trade, or they will lose all of their capital.
