Even if you feel very confident about your trading strategy, using one that results in a gain, say, 65% of the time, sooner or later you will incur in a losing streak. It is important to keep the chances of a serious drawdown occurrence, when a losing streak happens, to a minimum by using a proper risk/reward ratio when you place your next trade.
Let's say, you lose a series of trades, which bring your equity from an initial $10,000 to just $6,666.66. You lost 33% of your account, but how much do you have to get back to where you started from, relative to your current account?
If you answered 33%, you are wrong. The actual percentage you have to earn back is 50%. In fact:
Let's see what happens if you continuously lose 20% and win back 20% of your account.
Do you see where it is going? Due to drawdown, alternately winning and losing 20% (or any other percentage) of your account is not enough to stay even at the end of the day. This holds true even if you started with a winning trade — it would just take a bit longer.
As we hope you realized, recovering from a consistent loss in Forex, like in any other form of investment, gets increasingly harder. This is why you need to try avoiding serious drawdowns by using an adequate risk/reward ratio.
A risk/reward ratio is, like the term suggests, the ratio between the expected maximum loss and the maximum gain. The great thing about Forex trading is that you can calculate the R/R of your prospective trades beforehand (using stop-loss and take-profit values) and decide whether to take the trade based on its R/R ratio.
For instance, if your strategy tells you to place the stop-loss at 20 pips and your take-profit at 40 pips, your R/R ratio is 2:1. Please note that some traders use the "reward/risk" ratio term instead, but that does not really change anything. The conventional term is "risk-to-reward" ratio, not "reward-to-risk."
What is a good R/R ratio? If you understood what we just said about drawdown, you know that a ratio of 1 is not going to work in the long term! In fact, drawdown is precisely the reason why you should always enter trades with a stop-loss tighter than your take profit.
As an example, if you enter the trades solely with a risk/reward ratio of 2:1 and your strategy lets you win 50% of your trades, here is what your account will look like after alternately winning 20% and losing 10% of your account:
We offer a free gain/loss calculator, which can help you determine how much you have to win back after some loss in your account's balance.
Of course, entering in trades at random will not give you a 50% chance of winning, because the profit target is more distant than the stop-loss (and do not forget you have to factor in the spread, too). However, with the help of tools from technical analysis and a bit of experience, coming up with a strategy to earn this figure is certainly feasible.
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