You may have heard previously about the Risk Reward Ratio...... well what does that mean, I hear you say. Well the Risk to Reward Ratio is a ratio between the pre-defined Risk in a Trade and the pre-defined Reward in the same Trade. But what does this Ratio really mean....
The Risk Reward Ratio is a calculation that helps you quantify, in each trade opportunity, that there is satisfactory Reward to the Risk you are potentially taking on. This will help you to avoid trade opportunities where you are taking on Excessive Risk. As a rule it is good practice to only consider Trade opportunities which are 1 : 2 Ratio (Risk/Reward), though I prefer to be a bit more picky and look for 1:3 Risk Reward Ratio as it gives me better Trade Money Management.
Whether you trade Stocks, Options, CFD's, Futures or whatever, it is all calculated the same way. So how do you calculate you Risk Reward Ratio, let start with how do you pre-define your Risk.
1. Determine your risk.
When Defining your initial Trade Risk you are simply calculating your Entry Price Limit to your Initial Stop Loss, which will give you a monetary value that represents your risk or money that you are prepared to lose, if you are wrong. Now notice that I mentioned Entry Price Limit and not the current price, this represent the maximum you would be prepared to pay to enter the position. The maximum price you would pay also represent your maximum amount of risk your would also accept.
Now anyone can simply say I'll set my stop at -30% and set my Profit Target at +60% and achieve a 1 : 2 Risk/Reward Ratio, but it is much more realistic to use some kind of Technical support or resistance to define your Stops Loss point and Profit Taking Target points.
2. Limit the Risk.
Are there ways you can limit your risk. Here are some ideas:
- Set a Lower Entry Limit Price -If you miss entry, to bad there will be other opportunities.
- 2% rule - Risk only 2% of your account equity
- How much money will I lose
The second part of the Risk Reward Ratio calculation is Reward Analysis. When determining Reward component is important to estimate reasonable Profit Targets, which are realistic Reward for taking profits. It is good practice to use some kind of Technical Analysis to determine optimal areas to take profits like at resistance or support.
It is important to remember you have the greatest amount control, when sorting through trade opportunities, and using a tools like the Reward Risk Ratio can help you control your trade risk at the front end of the trade & target relatively Low Risk Opportunities. Therefore avoiding large capital draw-downs and living to trade another day, its a must have in any Trading Plan.
I hope that you are enjoying this blog series on the “Top 10 questions a Trading Plan must answer“. Below are all the posts in this series:
- What are your Life Goals & Trading Goals?
- What is your Trade Entry Method?
- What are your Trade Exit Methods?
- What type of orders will you use to enter & exit?
- What are your Money Management Techniques ?
- How will you manage your Position Risk versus Reward?
- What is your Process for Open Trade Review & finding New Trades Picks?
- What is your Trading Success Profile?
- How will you Review your Trading System to measure & improve?
- What is your Trading Daily Routine-(Part1 & Part 2)?
Stay tune for next weeks blog on “Open Trade Review”.
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