Controlling risk is the number one objective for investors. A disciplined trading plan focusing on quantifying loss exposure separates gamblers from those playing the long game.
Losses are a reality in trading, and only the amount relative to winners can be managed to push performance to profitability.
In theory a stock, commodity or currency has a 50/50 chance of going up or down from when you enter.
A one to one risk to reward ratio makes it difficult to be successful if the winning trades only pay for losers. That break even is before paying commissions to result in a net loss with that reward ratio.
Here are five points to think about risk and reward ratios:
- A mandatory stop loss is crucial , while not necessarily absolute risk control under all market conditions, reduces risk to a reasonable level compared no price protection. Every trade needs an exit strategy both when it moves in your favor and if it does not perform as planned.
- A starting point for many traders is a 2:1 reward to risk ratio. For every $5 at risk the desired objective is $10. Without the potential gain at least twice the loss many investors will pass on the play.
- Adjust stop to lock in gains to reduce risk. Never move a stop in a loser however to avoid being knocked out. Learn to play with house money when positions perform well by lowering dollar exposure. Moving stops to protect gains is an art and science. Moving the stops too close can knock you out in market fluctuations and eliminate more upside opportunity.
- Adapt risk to trading duration. A three to one reward to risk ratio may have advantages for more infrequent longer term trade styles. The development over weeks and months provide more time to be right. If wrong, a carefully selected swing trade setup needs to be right one out of three.
- Learn to be stopped out as a function of your risk plan if your expected result fails to occur. Being out is better than hoping that the position turns around.
Implementation of advantageous risk reward ratios can help better position for long term success to put the odds on your side.
