How much do you really know about the reward and risks of forex trading? Is there an absolute risk/reward ratio that traders should base their decisions on?
As with any other exchange platform that operates on the principles of trading and speculation, forex trading carries a certain level of risk on each transaction. In fact, it could be argued that forex day traders tend to assume more risk than those who venture into other financial markets.
Understanding the Reward and Risks of Forex Trading
The inherent risk of forex trading is that investors always stand to lose money on every trade, and the loss may range anywhere between one to 100 percent. Unlike the equity securities market, there are no stock certificates left to hold onto after a trade goes south; forex trading is completely liquid and speculative.
Forex trading at the retail level requires leverage in the form of margin; this requirement emanates from the minimum lot sizes, and it creates a spread that traders must first cover before they can even begin to think about taking profits. Of all day trading platforms, the retail forex brokerage space tends to be the busiest in terms of margin call; this is because the market is virtually open 24 hours a day and is very dynamic.
No risk/reward ratio can be reasonably recommended when it comes to forex trading. Choosing tolerance levels of 1:1 or 1:5 is irrelevant; what really matters is that traders realize that they can lose everything on each trade. For this reason, money management is a must in the world of forex trading.
To a certain extent, the concept of reward in forex trading is inverse to risk. Reward is the gross profit that can be taken on each trade before taking into account capital gains taxes. Even with margin calls, there is a limit to forex trading risk, which is losing all the money held in an online brokerage account; on the other hand, the sky is the limit when it comes to reward. It is important to note, however, that only about one percent of online forex traders achieve 100 percent profits; thus, reward can be assumed to be capped at the double rate for practical purposes.
Given the considerable risk faced by forex traders, they should only take market positions that follow acceptable principles of money management. A recommendation in this regard is to set up trades with stop loss features no greater than three percent. Beginner investors should target their stop loss to about two percent, and they should aim for a 1:5 risk/reward ratio to be on the safe side.
A good rule of thumb to remember in forex trading is that a loss of 50 percent will require a 100 percent return on the next trade just to get back to the point where the bad trade started.
In the end, disciplined forex traders will always worry about keeping their risk low while not even thinking about the reward. Forex profits can never be taken for granted, but their potential will remain as long as traders are active.