Read any trading book and there will be a lot of emphasis on following proper risk and reward on each trade. What does this mean and why is this important? Continue reading to know why proper risk: reward management is what will ultimately let you be profitable as a trader.
It is not just important to get the trade right. It is also important how much you make a trade. As a thumb rule, the risk on each trade should be half of the reward on that particular trade. The reward could, however, be higher but the reward should never be equal or less than the risk.
Why is it important
Following proper risk and reward on each trade are crucial because not all trades will be successful for you. Even the professionals have losing trades. If you keep a risk: reward ratio of 1:2, this means that on every trade you risk only half the money but win double. This is important because this is what will eventually let you be profitable
Suppose you take 100 trades and are profitable in 70 of them. This means that your account should be in positive. This, however, does not stand true all the time. If you have a risk: reward ratio of 1:1 or higher, then you will be losing more from the losing trades and making less money on the winning trades. This will eventually make your losses more than the winners and your account will be in a net loss.
How to calculate risk: reward ratio?
The risk is nothing but the stop loss on each trade. The reward is the profit target on each trade. You need to subtract the purchase price form the stop loss price and take the absolute value. This is your risk. You then have to subtract the target price form the purchase price and take its absolute value. This is the reward on the trade. Now divide the reward by the risk. This should be 2 or higher.
What if the trade does not meet the risk: reward ratio criteria?
There will be cases where the trade may not meet the risk: reward ratio. In these trades, the risk would be higher than the reward. You definitely cannot lower the stop loss price because then you are not leaving room for the price to move and thus there are high chances of your trades to get stopped out because of the volatility. Thus adjusting the stop loss price is not an option. You cannot increase the target price too because the target is the next resistance level and that is fixed.
In such cases, all that you do is overlook the trade and look for another opportunity that meets the risk: reward criteria.