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Learn advanced topics about trading strategies, risk management and more.

Protected: Lesson 5: Using the Risk/Reward Ratio in Trading

The risk /
reward ratio is used to determine the potential profit of a transaction
compared to its potential loss. To order to achieve the risk and reward of
trade, both the risk and the profit potential of trade must be identified by
the trader. Risk is calculated by means of a stop loss order, where the risk is
the price difference between the entry point of the exchange and the stop loss
order. The benefit goal is used to set the exit point if the trade moves
favorably. The potential profit for trade is the price difference between the
revenue target and the entry price.

If a
trader buys a stock at $25.60, sets a stop loss at $25.50 and a profit target
at $25.85, the trade risk is $0.10 ($25.60-$25.50) and the profit potential is
$0.25 ($25.85-$25.60).

The risk
is then compared to the benefit to determine the ratio: risk / reward=
$0.10/$0.25= 0.4

If the
ratio is greater than 1.0, the risk is greater than the potential profit on the
transaction. If the ratio is less than 1.0, the opportunity for gain is greater
than the risk.

Closer Look at the Risk / Reward
Ratio

It seems
that low risk / ratios of 0.1 and 0.2 are good, but that is not necessarily the
case. Traders must also consider the possibility that their gain goal will be
exceeded before their loss ends. You can make any trade look attractive by
placing your profit target far away from the entry point, but how often will
the market hit that high target before hitting a much closer stop loss level?

There is
therefore a balancing act between taking trades that give more benefit than
risk, but where trade still has a fair chance of reaching the target before the
loss ends. For most day traders, the risk / reward ratio is usually between 1.0
and 0.25, although there are exceptions. Day traders, swing traders and
investors must shy away from trades where the opportunity for gain is less than
what they put at risk, such as a risk / reward greater than 1.0. There are
enough attractive opportunities available that there is little reason to take
more risk for less money.

When
setting a risk / reward for a trade, position a stop loss at a logical location
on the graph according to your strategy, then set a logical profit target based
on your strategy / analysis. Such grades should not be chosen at random. Once
stop loss and gain target locations are determined, only then calculate the
risk / reward of the trade and evaluate whether the trade is worth taking. A
common mistake is that traders have a certain risk-reward ratio in mind. For
example, they would only want to risk $0.05 to make $0.20, so they go anywhere
and stop losing $0.05 and get a profit target of $0.20 back.

While this
may sometimes work, it’s not the perfect way to trade.

For trading
efficiently, have a trading plan in place that tells you exactly when and where
to sell and where to avoid your risk rates and goals under different market
conditions. Then have a policy that stipulates that you only take trades that
yield a risk / reward ratio of a certain amount or less.

Final Word on the Risk / Reward
Ratio

In
general, trades with lower risk / reward ratios are usually better off, as this
means that the opportunity for benefit outweighs the risk. Nonetheless, the
risk / reward does not have to be very small to be effective; anything below
1.0 is likely to produce better results than doing business with a risk /
reward ratio greater than 1.0. The risk / reward ratio is often used in tandem
with other risk management metrics, such as the win / loss ratio, which
measures the number of winning and losing trades, and the break-even figure,
which provides the amount of winning trades needed to break even.