I received an email from Ken who wrote:
Hi Mario, how do I calculate risk-reward ratio? For example, how do I know if the AUDCAD has a potential 2.5:1 risk-reward ratio?
Risk-Reward Ratio (RR) is used to compare the expected returns of an investment to the amount of risk undertaken to capture these returns. This ratio is calculated mathematically by dividing the amount of profit a trader expects to make when a position closes (i.e. the reward) by the amount he or she stands to lose if price moves in an unexpected direction (i.e. the risk).
Therefore, if you risk USD100 for a trade and aim for a profit of USD200, then your RR is 1:2.
The ratio is typically reflected as risk:reward. Thus, a risk:reward of 1:2 means the reward is twice the risk.
Since you quoted the AUDCAD, I shall use the hourly chart to illustrate an example. Let’s assume you enter a Long position for the AUDCAD at level 1.0000. Your stop loss is at 0.9950 (50 pips). If you target your profit to be at Take Profit 1 (TP1), then your RR would be 1:1, as TP1 is 50 pips from Entry Price. If you target TP2, then your RR would be 1:2, since TP2 is 100 pips from Entry Price. The RR for TP3 would be 1:3, as it is 150 pips away from Entry Price.Click the image to enlarge
To your success as a profitable trader,