Taking CALCULATED Risk...
To be a trader, you have to take risk when entering a position. But to be a consistently profitable trader, the risks you are taking are always well calculated. What does that mean, and how can we harness this principle to succeed/thrive more in life and in trading.
When you're an individual trader in the financial market (Stock, Forex, Crypto currencies) , one of the few safety you have is the risk/reward ratio calculation. Unfortunately, lots of beginning traders end up losing money when they try to invest on their own. There are many reasons for this, but one of those comes from their inability to manage the risk they are taking when entering a trade.
Risk/reward is completely objective, because numbers don't lie. Each person has his own tolerance for risk. You may love sky diving, but your friend might have a panic attack just thinking about it.
Risk/reward is a common term in trading, but what does it mean?
Let's say that you found a stock you like. That stock, ABC is trading at $10, down from a recent high of $15. You believe that if you buy now, ABC will go back up to $15 in the future, and you can cash in a nice profit. You have $1000 to put toward this investment, so you buy 100 shares. Do you know your risk/reward ratio you took? If you're like most beginning trader, you probably don't.
Here is how you can calculate your Risk/Reward. The calculation is very easy. You simply divide your net profit (the reward) by the price of your maximum risk. Using the ABC example above, if your stock went back up to $15 per share, you would make $5 for each of your 100 shares for a total of $500. You paid $1000 for it, so you would divide 500 by 1000 which gives you 0.5. That means that your risk/reward for this idea is 0.5 :1
Stop Loss, or How to limit your risk.
Inexperienced trader would often let that $1000 go all the way to zero, by not limiting their risk.
But every good trader has a stop-loss, to limit their risk. If you set a $15 to the upside, maybe you set $9 as the maximum to the downside. Once your stop-loss order reaches $9, you sell your ABC shares and look for the next opportunity. Because you limited your downside, your profit stays at $500, but your risk is now only $100 ($1 maximum loss multiplied by the 100 shares that you own), or 500/100 = 5 :1!!! You are basically risking 100$ to make 500$ !!!
Steps before entering a trade.
1. Pick a stock (ex. AAPL, MSFT..etc)
2. Set the upside (selling price) and downside (the risk your are willing to take) targets based on the current price.
3. Calculate the risk/reward ration (see calculation above) .
4. If it is below your condition, raise your downside target to attempt to achieve an acceptable ratio to your risk tolerance.
5. If you can't achieve an acceptable ratio, move on and start over with a different stock. Don't force yourself to take a trade base on hope.
If the risk/reward becomes unfavorable, don't be afraid to exit the trade. Never find yourself in a situation where the risk/reward ratio isn't in your favor.
With risk calculation, you make the conscious decision of taking a certain risk, knowing the potential upsides and downsides.
But always remember, no matter how smart or ingenuous you are, you will never be able to predict with 100% accuracy the trade you are taking, so be wise and always use stop loss to limit the possible downfall of your portfolio.
Take CALCULATED risks!
VTL
