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CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 62% of retail investor accounts lose money when trading CFDs with this provider.

You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

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Risk/Reward Ratios And Hit Rate

Not every trade will go exactly to plan. But calculating a risk-reward ratio for any new position will help you prepare forsurprises – and respond strategically. We’ll explain the simple rules behind RRR to help you manage risks and bettersustain long-term profitability.
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    Measuring your trading success

    When you first begin Forex trading, its vital that you epxand your knowledge of trading fundamentals. These include macroeconomic analysis, technical analysis, charting, and an understanding of the psychological impacts of trading. It’s also critical that you develop an approach to managing risk. Understanding risk comes from an apreciation of the different metrics that measure the success of a given trading strategy or system. Analysing different measures of trading success makes it possible to improve the results of any trading system or strategy, heightening profit potential and the returns from assets under management.

    In this section, we’ll look at two of the key metrics that you can easily measure and analyse in to improve your understanding of trading performance and the effectiveness of your overall strategy.

    These are:

    • The Risk/ Reward Rate
    • The Hit Rate

    We’ll also look at how both can be combined and analysed.

    Risk/Reward Ratio defined

    The Risk/Reward Ratio is a measure of the potential reward or profit that a trader or investor can expect from any given investment in terms of the potential risk of loss.

    For examle: if a trader was willing to risk losing £2 on trade and the potential profit target was £10, then the Risk/Reward Ratio would be 2:10 (or simplified to 1:5).

    It should be noted that any calculation is based on some hypothetical inputs. You can have a good idea of your potential risk by establishing a stop-loss (see our article on stop-losses here). The potential reward or profit is only a projected expectation before the trade or investment has even been entered into.

    Risk/Reward in practice

    Let’s consider real trading example to gain a better understanding of how the Risk/Reward Ratio works in practice.

    You’ve done initial analysis on the gold market and have decided you want to buy the equivalent of $1 per point movement. The current offer rice on gold is $1100, and you have a target for the next month for gold to reach $1200.

    This would then give you a potential profit of $1200-$1100, which is $100. By analysing your chart, you might see that there is strong support for gold at $1060, and decide to lace a stop-loss just below this support at $1050.

    This would then indicate a potential loss of $1100 minus $1050, so $50. The possible loss on the trade, therefore, as a ratio to the potential profit on the trade is $50 to $100, which gives you a 1:2 Risk/Reward Ratio.

    Clearly, the higher the Risk/Reward Ratio, the better the prospects for more substantial profits overall, but it’s vital also to consider how often your strategy is successful in picking winning trades.

    This brings us to the Hit Rate.

    Risk/Reward Ratios and Hit Rate

    The Hit Rate is typically defined as the number of winning or profitable trades over a period of time for a trading strategy, divided by the total number of trades over the same period, and expressed as a percentage.

    For example: if you have a trading strategy where you enter ten trades over a one-month period, and of these, six trades are winning trades, and four are losing trades, the hit rate is 6÷10, expressed as a percentage, which is 60 per cent.

    The Hit Rate is also sometimes expressed as a Win/Loss Ratio, or the number of winning trades divided by the number of losing trades to create a ratio. In the above examle, this would be 6:4 (or reduced to 3:2).

    Although the Hit Rate is an important metric and measure of the potential success of a trading strategy, it does not take into consideration the monetary value of each winning or losing trade.

    For this reason, it is useful to combine the measures of Hit Rate and Risk/ Reward Ratio to have a better understanding of the potential profitability of your trading strategy.

    Hit Rate and Risk Reward Ratios combined

    For any trading strategy, profitability and success will always be a trade-off between the Hit Rate and Risk/Reward Ratio.

    In most trading systems, achieving a higher Hit Rate usually means waiting for confirmation that the trade is going to be successful, which generally then lowers the Risk/Reward Ratio.

    Conversely, improvements in the Risk/Reward Ratio usually mean entering a trade at an earlier stage, which is sometimes detrimental to the Hit Rate.

    It’s the relationship between the Hit Rate and Risk/Reward Ratio that determines if a strategy will be profitable.

    Let’s look at an example:

    Trader 1: Profiting with a high Hit Rate and low Risk/Reward Ratio.

    • Hit Rate 60% and Risk/Reward Ratio 10:6 (or 5:3)
    • 10 trades, 6 wins of £60, four losses of £100
    • Outcome: £40 loss

    Trader 2: Losing with a High Risk/Reward Ratio and low Hit Rate.

    • Hit Rate 30% and Risk/Reward Ratio of 1:3
    • Ten trades, three wins of £300, seven losses of £100
    • Outcome: £200 in profit

    So, in the diagram below, any combination of Hit Rate and Risk/Reward Ratio above the curve indicates a profitable
    strategy, while any combination below the curve results in a losing strategy.

    Risk/Reward Ratio vs Hit Rate for Break-even Performance

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