Why Forex Traders Use Risk–Reward Ratios and Need a Trading Edge
Summary
The answer explains that a 1:2 risk–reward ratio is a convention rather than a universally correct rule. It offers two possible reasons traders favor it: loss aversion may lead investors to seek more potential gain than potential loss, and a reward-to-risk target of two is loosely associated with a Sharpe ratio of two. The response cautions that this association is not a guarantee of live performance, since backtests can mislead and traders may struggle to follow a strategy through drawdowns.
For a new forex trader, the answer recommends learning technical analysis as a market-timing tool while emphasizing that it alone does not establish profitability. It argues that traders need an edge and suggests that quickly processing information may help because information does not diffuse instantly. These are broad opinions, not tested guidance: the answer does not define how to measure an edge, validate a risk–reward target, or substantiate its claims about news and professional decision-making.
Key ideas
- A 1:2 risk–reward ratio is a convention, not a magic threshold.
- Loss aversion is offered as one explanation for seeking more potential gain than loss.
- The answer loosely connects a reward-to-risk target of two with a Sharpe ratio of two.
- Technical analysis may help with timing but does not by itself establish a profitable strategy.
- A trader needs an edge and the discipline to follow it through drawdowns.
Tags
Full text
# What is the required Risk/ Reward ratio in Forex? # What is the required Risk/ Reward ratio in Forex? It is usually taught in forex training courses that the risk:reward ratio should be 1:2. My question is: why is it 1:2 but not other ratio? Also, I am new to forex trading. To what level of technical analysis (TA) should I know in order to be able to trade? My friend told me that: you just need basic TA (some basic indicators), it is more about understanding the psychology of the crowd (thus human) and how determined and discipline you are. Is he true? ## Answer by Simon (score 0, accepted) https://quant.stackexchange.com/a/14635 Regarding risk reward ratio, there is no magic about the number 2. However, demanding a ratio of 2 does make practical sense. We may look at it in two-folds: From behavioural finance point of view, investors generally demand more (2 dollars) profits for certain amount (one dollar) of loss. This skewed heuristic of decision making has been explained well in Daniel's Prospect Theory, which is dictated as investor's common tendency of Loss Aversion. From portfolio management point of view, reward/risk of 2 loosely implies Sharpe ratio of two, which is a widely followed standard to determine the superiority of a tradable strategy. Sharpe ratio of less than that in simulation is hardly to achieve consistency and low draw down in live trading, given all the pitfalls of backtesting and trader's incapability to carry forward trading during stressful draw down period. Ernie Chan also once argued about this view in his article The importance of 2. Your next question of forex trading deserves a separate post by itself. My quick answer would be: - Technical analysis is worth learning. It gives a tool for market timing. However, it is not sufficient for you to achieve profitability on trading. - News is almost useless. They are often already priced and never new. Believe me or not, professionals rarely make decisions based on news. However, processing of large amount of news quickly offers an edge, as information diffusion is not immediate. - In trading, you need to have an edge. If you don't have one, then create one before starting. Hope it helps.
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