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May 25, 2018

A Simple Way to Calculate Risk and Reward


It’s important for traders of all skill levels to understand the risk and reward dynamics of every trade they put on.

To profit in the long run, it’s a good idea for you to risk less than you can potentially make in a trade.

This means that when you have a losing trade, you will lose less than you’d make in a winning trade of the same size.

Making sure you set up your positions in this way is essential to good risk management.

Throughout my trading career, there haven’t been many times where I would even consider taking a trade when my loss potential was greater than my win potential.

Using the “profit factor” keeps your reward-to-risk ratio where it should be.

Below I show you how to use the profit factor to set up each trade for profit, and therefore, set up your portfolio for success in the long run.

What Is The Profit Factor?

The profit factor is simply the ratio between your profits and your losses. It’s a simple calculation.

Example: Say, after one week of trading, you’ve earned $400 in your winning trades and lost $200 in your losing trades. Your net profit is $200.

Your profit factor is: $400/$200 = 2. (The ratio between the profits in your winning trades and losing trades.)

You always want your profit factor to be above 1. This means that your winning trades are profiting above your losses, and that you are netting out with positive results at the end of the week.

Setting yourself up to do this is simple: calculate your profit potential and loss potential at the onset of the trade. If the ratio between those two number is less than 1, don’t take the trade.

Calculating Potential In A Stock Trade

Always calculate the potential of every stock trade. It will tell you if the trade is a winning bet or a losing one.

Example: You buy 10 shares of stock XYZ at $100 with a stop at $90 and a profit target at $105.

If you hit your profit target in this trade, you would make $50 ($5 profit per share x 10 shares).

If you hit your stop loss, you would lose $100 ($10 loss per share x 10 shares).

The ratio between potential profits and potential losses is: $50/$100 = 0.50.

The reward-to-risk ratio is below 1, so the loss potential is greater than the profit potential. This is not the type of trade you want to take.

Trading setups like this will make it very difficult to profit in the long run because you’ll need to be right much more often than you’re wrong.

A Positive Reward-To-Risk Ratio Is Key

Keeping these things in mind has been the key to my success as a trader.

If you do the same, and give yourself the opportunity to make good reward-to-risk ratio trades, you will find that in the long run, it’s much easier to be successful.

Remember this and you will be setting up trades like a real pro!

Courtesy of Andrew Keene, Wall Street Daily (More from Wall Street Daily Here)    

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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