Risk reward ratios are a critical component to successful trading. Trading can quickly become gambling if you continue to press your bets by taking positions with poor risk reward ratios. While identifying good risk reward ratios does not guarantee success, ignoring them usually guarantees failure.
Candlestick traders look for patterns with proven higher probabilities for placing trades. Once the pattern is identified, the next step is determining entry and exit points. For both, profit targets and stop loss targets. These points can be determined based upon moving averages, Bollinger bands, or other technical indicators to evaluate possible support and resistance levels. The onslaught of computerized trading programs provides traders with quick calculations to base one’s risk/reward targets.
Calculating Risk Reward Ratios
Let’s assume our computerized scanning program provides us with a dozen high probability patterns from which to choose. Most traders will only be able to add one or two new positions to their portfolio. This is where utilizing risk reward ratios come into play.
The simplest calculation will take into account:
1) Entry Price
2) Profit Target
3) Stop Loss Target
For example:
Stock XYZ has the Entry Price of $20.35 with our Profit Target of $21.50 and Stop Loss target of $19.85. Our Risk = the difference between our Entry Price of $20.35 and our Stop loss of $19.85 or Risk = .50. Our Reward is the Entry Price of $20.35 plus the Profit Target of $21.50 or Reward = $1.15. We are risking .50 to make $1.15. In this example a little better than a 2:1 ratio.
The rule of thumb for a reasonable risk reward ratio is a minimum of 2:1. It is important to analyze your potential loss in the event your analysis is wrong and the trade does not follow in the expected direction. And, no fair setting your targets using fuzzy math! The risk reward ratio is meant to provide an unemotional evaluation before risking your hard earned money. Don’t ‘jiggle’ the figures to justify the trade.
Use this approach to narrow down your trades until you find the highest probability patterns with the greatest risk reward ratio. The more systematic you become in evaluating your trades the more likely your portfolio will prosper. Additionally, this approach helps to remove emotional trading which is a continued struggle for many investors.
Where to Begin
Evaluate your previously closed positions, using both your winning and loosing trades. Since you should constantly be evaluating your previous trades to evaluate the success of yourmost important technical analysis tools, you will kill two birds with one stone. Yes, I realize this is a boring exercise but it is essential to your success. The old adage ‘Insanity is doing the same thing over and over again but expecting a different outcome’ was never more true. At least take the time to consider whether you want to add the risk reward ratio to your trading criteria.
There is another other element to consider after the risk reward ratio has been determined. What is the length of time you expect to be in the trade? The shorter the time period the more trades you can place and the more money you can make. A 5:1 ratio is less attractive if your opportunity money will be tied up for too long a period. You must use your capital on the highest probability trades. Using the simple risk reward ratio should produce more profits to your portfolio.
To summarize; you should be willing to risk $1 to make $2. You should not be willing to risk a $1 to make a $1. Keep it simple and keep your targets honest, (the data is only as good as the person plugging in the figures).
By doing the risk reward calculations for every potential trade you will have your exit criteria before placing your trade. This keeps you from getting greedy when your profit target has been reached. You can take your profit and re-enter if the new trade meets your criteria. This also helps you from dropping your stop-loss, in the hopes that your trade will soon go your way.
What if I determine one of my open positions has a poor ratio?
Over the years, I have found one of the best ways to evaluate if it is time to take a loss is to look at my existing trade as if I were considering placing it today. If I could not justify taking it at the current price, using the same criteria I use for entering a trade, then it is time to take a loss. If you would not buy it today then more than likely, you already know the answer. Allowing your losses to grow is not a good habit to get into. Hoping and praying are not profitable stock market trading tools. The key is to win more than you lose. Loses are simply the cost of doing business. Every business has an income and expense allowance andcandlestick stock trading is no different.
Candlestick traders look for patterns with proven higher probabilities for placing trades. Once the pattern is identified, the next step is determining entry and exit points. For both, profit targets and stop loss targets. These points can be determined based upon moving averages, Bollinger bands, or other technical indicators to evaluate possible support and resistance levels. The onslaught of computerized trading programs provides traders with quick calculations to base one’s risk/reward targets.
Calculating Risk Reward Ratios
Let’s assume our computerized scanning program provides us with a dozen high probability patterns from which to choose. Most traders will only be able to add one or two new positions to their portfolio. This is where utilizing risk reward ratios come into play.
The simplest calculation will take into account:
1) Entry Price
2) Profit Target
3) Stop Loss Target
For example:
Stock XYZ has the Entry Price of $20.35 with our Profit Target of $21.50 and Stop Loss target of $19.85. Our Risk = the difference between our Entry Price of $20.35 and our Stop loss of $19.85 or Risk = .50. Our Reward is the Entry Price of $20.35 plus the Profit Target of $21.50 or Reward = $1.15. We are risking .50 to make $1.15. In this example a little better than a 2:1 ratio.
The rule of thumb for a reasonable risk reward ratio is a minimum of 2:1. It is important to analyze your potential loss in the event your analysis is wrong and the trade does not follow in the expected direction. And, no fair setting your targets using fuzzy math! The risk reward ratio is meant to provide an unemotional evaluation before risking your hard earned money. Don’t ‘jiggle’ the figures to justify the trade.
Use this approach to narrow down your trades until you find the highest probability patterns with the greatest risk reward ratio. The more systematic you become in evaluating your trades the more likely your portfolio will prosper. Additionally, this approach helps to remove emotional trading which is a continued struggle for many investors.
Where to Begin
Evaluate your previously closed positions, using both your winning and loosing trades. Since you should constantly be evaluating your previous trades to evaluate the success of yourmost important technical analysis tools, you will kill two birds with one stone. Yes, I realize this is a boring exercise but it is essential to your success. The old adage ‘Insanity is doing the same thing over and over again but expecting a different outcome’ was never more true. At least take the time to consider whether you want to add the risk reward ratio to your trading criteria.
There is another other element to consider after the risk reward ratio has been determined. What is the length of time you expect to be in the trade? The shorter the time period the more trades you can place and the more money you can make. A 5:1 ratio is less attractive if your opportunity money will be tied up for too long a period. You must use your capital on the highest probability trades. Using the simple risk reward ratio should produce more profits to your portfolio.
To summarize; you should be willing to risk $1 to make $2. You should not be willing to risk a $1 to make a $1. Keep it simple and keep your targets honest, (the data is only as good as the person plugging in the figures).
By doing the risk reward calculations for every potential trade you will have your exit criteria before placing your trade. This keeps you from getting greedy when your profit target has been reached. You can take your profit and re-enter if the new trade meets your criteria. This also helps you from dropping your stop-loss, in the hopes that your trade will soon go your way.
What if I determine one of my open positions has a poor ratio?
Over the years, I have found one of the best ways to evaluate if it is time to take a loss is to look at my existing trade as if I were considering placing it today. If I could not justify taking it at the current price, using the same criteria I use for entering a trade, then it is time to take a loss. If you would not buy it today then more than likely, you already know the answer. Allowing your losses to grow is not a good habit to get into. Hoping and praying are not profitable stock market trading tools. The key is to win more than you lose. Loses are simply the cost of doing business. Every business has an income and expense allowance andcandlestick stock trading is no different.
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