/Getting the risk reward equation right while trading
Risk / reward analysis is a very important aspect of initiating a trade. As the name suggests, risk / reward analysis helps to identify the potential return from a given trade compared to the amount of risk being taken. Ideally, you want at least a two-to-one ratio – two points of profit for every one point of risk.
Risk/reward is just what the name implies. It is the process of evaluating how much risk you will take on compared to how much reward you can expect to gain on any given trade. Or said another way, how many points could the stock fall if the trade doesn’t work out, versus how many points could the stock rise if the trade does in fact go in your favor? Typically, when evaluating risk/reward, we like to see a two-to-one ratio, at a minimum. In other words, for every point of risk, we want to have two points of potential reward.
So, as the above suggests, you need to be able to determine the expected reward and the potential risk. How do you do that? Well, a few things are needed to calculate the amount of risk versus reward.
* Determine where significant resistance lies ahead, or where the stock would be overbought on its trading band.
* Determine where significant support resides below.
* Calculate the price objective for the stock, using either the vertical or horizontal count.
* Determine one’s stop-loss point – where the stock will break a significant bottom or trendline, the point at which you no longer want to own the stock. You must be able to handle the worst-case scenario – that of the trade not working, and therefore being stopped out.
Examples
Here are a few examples of the risk-reward ratio:
* If the risk is Rrs200 and the reward is rs400, then the risk-reward ratio is 200:400 or 1:2.
* If the risk is rs500 and the reward it rs1,500, then the risk-reward ratio is 500:1500 or 1:3.
* If the risk is rs1,000 and the reward is rs500, then the risk-reward ratio is 1000:500 or 2:1.
What is a Good Risk-Reward Ratio?
The minimum risk-reward ratio for a trade is 1:2. However, a larger ratio is better. An acceptable risk-reward ratio for beginning traders is 1:3. Any number below 1:3 is too risky so the trade should be avoided. Never enter a trade in which the risk-reward ratio is 1:1 or the risk outweighs the reward.
Many experienced trader will only enter trades in which the risk-reward ratio is 1:5 or higher. This requires that the trader wait for a trade with this ratio, but the reward is worth it. A higher risk-reward ratio is a good idea in case the stock does not make the anticipated price movement. However, if the trader uses a lower risk-reward ratio, there is very little room for smaller price movements and the amount of risk will increase.
The risk-reward ratio is an important risk management and trading tool. It is important for beginning traders to take the extra time to perform this task because it can help to minimize risk in every trade. Waiting for the right risk-reward ratio can take a long time. However, the benefits of waiting for a higher risk-reward ratio are worth the effort and patience. You will know your risk and know your potential profit. Most importantly, you will know whether the trade is worthy of your money.
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