When you invest your money to whatever investment vehicle you opt in to, you are entering a deal that has both risk and reward situation. Playing the Stock Market game without a proper risk-reward ratio set up is the same as gambling where you are set up to loose no matter what.
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What is Risk?
It is a situation of having a controlled possible losses when an investment turned against you. This is the amount of money you are willing to let go but still having the composure to sleep soundly at night.
What is Reward?
On the other hand, reward is a controlled situation where you have possible gains if an investment is in your favor. This is the amount of money you are willing to have before you exit an investment.
What are the ideal Risk-Reward Ratio Set Up?
One is to One (1:1) – The reward is equal to the risk, this is used by day traders where the environment is fast phased. This is ideal for traders who are not holding stock positions overnight. Hence, they are called day traders.
One is to Two (1:2) – Ideal for non-day traders, the reward must be twice as high than the risk. For example, if your risk is 100 then your reward should be at 200.
How do you compute the Risk:Reward Ratio?
Below are the mandatory requirements:
- Target Price (TP)
- Entry Price (EP)
- Stop Loss Price (SLP)
Risk:Reward Ratio = (TP – EP) / (EP – SLP)
Example:
TP is 35, EP is 25, and SLP is 22.
Risk:Reward Ratio = (35 - 25) / (25 - 22)
Risk:Reward Ratio = (10) / (3)
Risk:Reward Ratio = 3.3333
Risk:Reward Ratio = 1:3.33
Given the figures above, the trade that you will be entering is a very good deal. If you enter at 25 and if the odds are in your favor you will exit at 35. This is a 10 point increase. Otherwise, if the trade goes south, you will exit at 22 risking only 3 points.
Don't enter a trade because you feel like it. Enter with a proper Risk Reward Ratio set up.
Stay tuned for the Risk Reward Ratio Calculator that accounts both buying and selling fees.
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