Consider Risk/Reward Ratio in Trading

For traders, learning risk/reward ratio in trading is worth your time and essential for trading success

. In daily live, we unconsciously weight risk before we do anything, including buying something, quitting your job or even putting your hand on hot stove. However when it comes to trading, traders are often careless about this.

If you have ever read my articles, you may notice that I have always mentioned that a complete trading system must consist of rules for entry, exit and stop loss. The key of exit and stop loss is you have to set them before enter a trade.

There are many reasons behind this approach. One reason is it enables you to calculate your risk/reward ratio for your trade. Since you have your specific target price and stop price, you are able to measure your risk (when you are stopped out) against your reward (when the price reaches your target).

A general criterion for risk/reward ratio is to enter a trade only when your profit target (reward) is at least two or more times greater than your stop loss point (risk).

Let's take a look at the following scenario of trading. Learn to recognize trades that are high risk and try to minimize its risk.

Let says that you follow the breakout system when you trading a stock. You are taking chance when you buy it on a breakout.

Before the breakout, the price level at breakout usually works as a resistance, therefore there is chance that the price will go down again and form the double top reversal pattern. Actually, it is often to be that way rather than the price really breaks the level out.

So the questions are:

1. Where is your stop loss point? If you place the stop at the support level before the breakout, it will be several ticks away from your entry.

2. Where is the next resistance level? How far is it when compare to the stop.

By answering these two questions, you will get the idea of your risk and reward. If you place the stop at the support level before the breakout, you are taking high risk. It is better for you to set the stop fewer ticks below the breakout level, this way you can minimize your risk and it requires lower level of target price to be at least two times greater than your possible loss.

The bottom line of the story is you must consider your risk and reward for your trade according to your entry, stop and exit! Do not take that trade if it is not worth.

Consider Risk/Reward Ratio in Trading

By: Taro Hideyoshi

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