Risk vs. reward is a fairly simple, straight-forward concept. Risk amount is determined by where your stop loss is on your trade, in combination with your entry price and size on that trade.
Simply multiply the difference between your entry price and your out by the share size you are taking to determine your total dollar risk on a given trade.
“Out” is the term we use for stop loss level. So what you’re risking is the difference between your entry point and that stop loss.
For example, if you’re buying a stock at $50.00 and your stop is at $49.90, you’re risking 10 cents.
$50 (Buy) – $49.90 (Stop) = $.10 Risk
Reward, simply put, is where you think the stock can go.
For example, you’re buying a stock at $50.00, and you think for whatever reason that stock can have a move up to $50.50. What’s your risk-reward?
In this case, you’re risking 10 cents to make 50 cents; in other words, you’re risking 1x to make 5x. That’s a risk reward ratio. It’s something that you need to think about every time that you are creating a game plan for any trade.
$50 – $49.90 = $.10 x 1000 shares = $100 Total $ Risk
The reward is as follows:
$50.50 (Target) – $50.00 (Entry Price) = $.50 x 1000 shares = $500 Total $ Reward
One of the most important factors I’m always paying attention to when analyzing technicals is multiple time frame continuity. For example, when a stock or market’s chart is trending higher on a 5 minute time frame, as well as a 15 minute, daily, and weekly time frame. This is vital for thinking about reward potential when it comes to swing trading with the trend.
I like to think about the concept of unlimited reward. That’s the best risk reward ratio you could have.
In a trade where you are long with the trend, a certain amount of defined risk can yield potentially unlimited reward (only true for long plays). The best way to capture these rewards is to have a game plan in place where you can implement trailing strategies to maximize reward.
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– Derrick Oldensmith
Senior Trader and Managing Supervisor