Chapter 6: Risk / Reward

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Large losses will quickly dwindle a trader´s account, and small wins will do little to pay for those losses.

Successful trades have to be asymmetric, where the downside is carefully planned and managed, but the upside is open ended. This is crucial element for a trading success, and has to be understood, planned for, and carefully executed

Keys to risk/reward ratio. Do the math

The ratio is calculated mathematically by dividing the amount of profit the trader expects to have made when the position is closed(the reward), by the amount the trader could lose if they are stopped out for a loss

Understand your odds.

Understand that even the best traders only win about 50-60% of the time.

Cut your losses

Constantly remind yourself that cutting losses quickly will be the key to your success

In order to trade confidently and win 50-60% of the time, a trader must carefully analyze their trades by accurately calculating their risk/reward ratio

Win rate vs. risk/reward Ratio

The bigger your winning trades, the lower your win rate must be to become profitable. You don´t have to be right all of the time, you just have to be right big, and wrong small.

Risk/reward Facts

With a 1:1 rist/reward ratio and 50% win rate a trader breaks even

With a 2:1 risk/reward ratio and about 35% win rate a trader breaks even

With a 3:1 risk/reward ratio and about 25% win rate a trader breaks even

The key to discovering your risk/reward ratio is to first determine where price has to go to show you that you are wrong. This is usually the key support level, and what you use to place your stop loss. Your potential profit target will be set as a rally to a key resistance level or a new all-time high. Remember that your stop loss level is your risk, and your target is your reward. Allowing one of the two to play out is the key increasing your odds of profitability.

High winning percentages are difficult for many traders, especially with tight stop losses

A great formula to use is a 3:1 risk/reward ratio

Keys to 3:1 risk / reward ratio

Know the upside

Know how much you will risk on any one trade, and then don´t enter a trade where the upside is not at least three times your risk of loss, if your stop is hit.

Measuring risk

Understand that with a 3 to 1 ratio, you can risk 1% of your trading capital for the possibility of making 3% of your capital in profits

Cutting your losses

You can cut losses before your stop is hit, but you must allow enough room for normal fluctuations and volatility

Let your winners run

Allow winners to run as far as possible with the use of trailing stops. You never know when you will have a big win, with the right entry and trend

A great formula to use is a 3:1 risk/reward ratio, with this ratio a trader is risking $100 to make $300. If 100 shares of stock are bought for $30 a share and the stop is at $29 then the stock should only be purchased if it is probable that the stock could run to $33 based on the chart pattern or back tests. At $33 share price profits could be taken or ideally if ir tuns to $34 a trailing stop could be set at $33 to give the stock an opportunity to be an even bigger winner but set the trailing stop to lock in the $3 per share gain

However if you allow losers to run hoping they will come back so you can take profits on a rebound then you can get into trouble fast

I also recommend you to allow winners to run as far as possible with the use of trailing stops

First know how much you will risk on any one trade then do not enter a trade where the upside is not at least three times your risk of loss if you stop is hit.

What we learned

It is not the winning percentage of a trader that determines their profitability but the size of all their winning trades versus the size of all their losing trades. The fastest path to profitability is to trade with a process that maximizes winning trades and minimizes the losing trades.