The risk reward ratio is simply a calculation of how much you are willing to risk in a trade, versus how much you plan to aim for as a profit target. To keep it simple, if you were making a trade and you only wanted to set your stop loss at 5 pips and set your take profit at 20 pips, your risk: reward ratio would be 5:20 or 1:4. You are risking 5 pips for the chance to gain 20 pips.
How to use a risk reward ratio in forex trading
The basic theory for risk: reward ratio is to look for opportunities where the reward outweighs the risk. The greater the possible rewards, the more failed trades your account can withstand at a time. Think of it this way, if you were to use the example above and have a successful trade, it would buffer you against 4 losing trades with the same ratio.
The idea of using a good risk reward ratio is to put the odds in your favor. If you consistently did the 5:20 ratio, you could lose half of your trades, and still make a decent profit.
Typically, risk: reward is useful when the price is near important support or resistance. For example, if EUR/USD is in a downtrend and price has stalled near resistance and could be posting a lower high, the risk: reward would likely favor a sell trade with a smaller protective stop above the entry and a larger take profit in the direction of the trend.
What types of risk reward ratio should a trader use?
The type of risk reward ratio that traders should use really depends on the type of trader you are, and the market conditions.
It would be ideal if you could always find trades that had high rewards and low risk, but what you might find in reality could be very different.
It's generally frowned on to have a risk that is larger than the reward, but if markets are volatile, it might make sense. The point of having a stop loss is not only to protect capital but also to stop your trade once it no longer makes sense.
Sometimes the point where the trade stops making any sense is much farther from the opening market price than the safe exit.
When it comes down to it, it is up to you as a trader to figure out what type of risk reward ratio you want to use. You should try to avoid having your risk be bigger than your reward, particularly if you are a beginner, but there is no particular ratio that works for all traders. The important thing is that you use a ratio that makes sense for your trading style and for market conditions.