What is Risk Management? You want to be the rich statistician and NOT the gambler.

What is Risk Management?

This section is one of the most important sections you will ever read about trading.

Why is it important? Well, we are in the business of making money, and in order to make money we have to learn how to manage risk (potential losses).

Ironically, this is one of the most overlooked areas in trading. Many traders are just anxious to get right into trading with no regard for their total account size.

They simply determine how much they can stomach to lose in a single trade and hit the "trade" button. There's a term for this type of investing....it's called...

GAMBLING!

When you trade without money management rules, you are in fact gambling.
You are not looking at the long term return on your investment. Instead you are only looking for that "jackpot".

Money management rules will not only protect you but they can make you very profitable in the long run. If you don't believe us, and you think that "gambling" is the way to get rich, then consider this example:

People go to Las Vegas all the time to gamble their money in hopes of winning a big jackpot, and in fact, many people do win.

So how in the world are casinos still making money if many individuals are winning jackpots?

The answer is that while even though people win jackpots, in the long run, casinos are still profitable because they rake in more money from the people that don't win. That is where the term "the house always wins" comes from.

The truth is that casinos are just very rich statisticians. They know that in the long run, they will be the ones making the money--not the gamblers.

Even if Joe Schmoe wins $100,000 jackpot in a slot machine, the casinos know that there will be hundreds of other gamblers who WON'T win that jackpot and the money will go right back in their pockets.

This is a classic example of how statisticians make money over gamblers. Even though both lose money, the statistician, or casino in this case, knows how to control its losses. Essentially, this is how money management works. If you learn how to control your losses, you will have a chance at being profitable.

In the end, Forex trading is a numbers game, meaning you have to tilt every little factor in your favor as much as you can. In casinos, the house edge is sometimes only 5% above that of the player. But that 5% is the difference between being a winner and being a loser.

You want to be the rich statistician and NOT the gambler because, in the long run, you want to "always be the winner."

So how do you become this rich statistician instead of a loser?

Read more: 

http://www.babypips.com/school/what-is-risk-management.html#ixzz1ebTZDg9e

Risk reward ratios are a critical component to successful trading but does not guarantee success.

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.

http://www.candlestickforum.com/blogs/2006/07/risk-reward-ratios.html

Reward-to-Risk Ratio

Another way you can increase your chances of profitability is to trade when you have the potential to make 3 times more than you are risking. If you give yourself a 3:1 reward-to-risk ratio, you have a significantly greater chance of ending up profitable in the long run. Take a look at this chart as an example:

10 Trades	Loss	Win
1	$1,000
2		$3,000
3	$1,000
4		$3,000
5	$1,000
6		$3,000
7	$1,000
8		$3,000
9	$1,000
10		$3,000
Total	$5,000	$15,000

In this example, you can see that even if you only won 50% of your trades, you would still make a profit of $10,000. Just remember that whenever you trade with a good risk to reward ratio, your chances of being profitable are much greater even if you have a lower win percentage.

BUT...

And this is a big one, like Jennifer Lopez's behind... setting large reward-to-risk ratio comes at a price. On the very surface, the concept of putting a high reward-to-risk ratio sounds good, but think about how it applies in actual trade scenarios.

Let's say you are a scalper and you only wish to risk 3 pips. Using a 3:1 reward to risk ratio, this means you need to get 9 pips. Right off the bat, the odds are against you because you have to pay the spread.

If your broker offered a 2 pip spread on EUR/USD, you'll have to gain 11 pips instead, forcing you to take a difficult 4:1 reward to risk ratio. Considering the exchange rate of EUR/USD could move 3 pips up and down within a few seconds, you would be stopped out faster than you can say "Uncle!"

If you were to reduce your position size, then you could widen your stop to maintain your desired reward/risk ratio. Now, if you increased the pips you wanted to risk to 50, you would need to gain 153 pips. By doing this, you are able to bring your reward-to-risk ratio somewhere nearer to your desired 3:1. Not so bad anymore, right?

In the real world, reward-to-risk ratios aren't set in stone. They must be adjusted depending on the time frame, market environment, and your entry/exit points. A position trade could have a reward-to-risk ratio as high as 10:1 while a scalper could go for as little as 0.7:1.

If you want a real world example of traders trying to maximize reward-to-risk ratios, you should check out Pipcrawler's Pick of the Day blog and Cyclopip's Weekly Winner. Pipcrawler normally takes trade setups that have at least 2:1 ratios, while Cyclopip pinpoints the best setups from the previous week that would have maximized his profits.

Read more:

http://www.babypips.com/school/reward-to-risk-ratio.html#ixzz1ebPybKrS

The risk/reward ratio is a lie. It is a fun fantasy,

Risk-Reward

Apples and Unicorns; The 'Risk/Reward' Ratio ...is a LIE (unless you're an unusual kind of trader). 


The risk/reward ratio is a lie. It is a fun fantasy, but because one of its components has a horn, it does not exist. If a salesman calls you up (I won't even call him or her a broker) and tells you he has a dynamite trade in Wheat, as evidenced by the risk/reward ratio of 8 to 1 profit to risk, just say no. It is NOT real. Take that trade only if there is something else out there that's convincing.


Don't compare the risk/reward ratio (i.e. don't take the expected risk on a trade and comparing it to the expected return) - use the risk/account ratio instead (i.e. the amount you're risking to the amount in your account).


Read more here:
http://www.financial-spread-betting.com/Risk-reward.html

Calculating Risk/Reward Ratios

Calculating Risk/Reward Ratios

Risk to reward ratios. If there is a cornerstone to any trading philosophy, it starts at the risk to reward table. Although identifying good risk/reward trades does not guarantee success, not identifying good risk/reward trades almost always guarantees failure. Let's explore yet another important subject in the life of a trader and look at a trade setup we took late Friday in the context of this subject matter.

Determining a Good Risk/Reward Trade

Contrary to popular thought, successful traders can take on any type of trade in terms of size and risk as long as they first understand the implications of the trade and are willing to stomach the losses should they occur. If a trader feels that they have the hot hand, they may choose to press a bet (to make a larger than normal purchase or sell on the belief that the odds are in their favor). They do this knowing that they may suffer greater than normal losses if the trade doesn't pan out. Traders do this all the time.

It is critical, if you are to be successful, to understand that trading is a game of probabilities. Technical traders are simply looking for patterns with a greater than 50/50 chance of repeating themselves over and over again. Once such patterns are identified, traders attempt to recognize such patterns in current charts and then identifying entry and exit points based on those charts. Entry and exit points are typically associated with support and resistance areas of the charts. Ah, support and resistance areas. These were the tools of the early traders, traders that read the tape ... traders that were successful at technical analysis long before the advent of all these derivative indicators, these answers to the problem of technical trading, this onslaught of technical wizardry. The oldest and purest form of technical analysis is support and resistance. Understanding it provides a large portion of the technical analysis that one needs to be successful at identifying entry and exit points.

Calculating the Risk/Reward Trade

In previous chapters we have talked about the need to identify potential trades based on chart patterns. The idea is that you collect a set of candidate charts, charts that have positive prospects for immediate or reasonably near term trading time frames. It is with these candidate charts that one can dig deeper into the possibility of trading that particular issue. The identification of a probable trade centers around the proper identification of realistic entry and exit positions based primarily on support and resistance. Once you have properly identified the support and resistance points you can take those numbers, plug them into a simple spreadsheet and calculate the risk reward. The simplest form of calculation involves nothing more than the following:

Entry Price
Stop Loss Target
Stop Profit Target
The resulting Risk/Reward Ratio

Now, let's apply this to a particular trade. The following graph shows NEM as it looked on May 17th, 2002. Gold is enjoying a significant run up and this trade actually goes against the prevailing trend, attempting to time a quick short trade based on chart patterns. On the fundamental side, there is concern that gold could continue to rise as the dollar continues to weaken and as world events dictate increased fear on the terrorism front. On the other side of the coin, the technical picture shows a potential short candidate given the annotations provided below.

View image here.

Given the chart above, here's an example of the most simplistic risk/reward ratio calculation.
In the end, it turns out that world events and the spot price of gold ended up making this trade a losing trade, but risk to reward calculation remains the same ... regardless if the trade wins or loses.

Ranking Trades and the Spreadsheet

To see if a potential play is worth wagering money on, one must determine what the potential losses are if your analysis is wrong, and what the potential gains are if the analysis is correct. You should always shoot for a minimum of 2:1 ratio, that means that your potential profit should be roughly 2 times your potential loss. This is a rule of thumb that many traders use ... especially the good ones. In the example above, if one enters a trade at the price of $29.12 with a define stop loss exit of $30.68 and a potential target exit for profits at $26, then the ratio is roughly 2:1 (a bit less in this case). That's it. It's really that simple.

Recognize that once one has entered such a formula into a spreadsheet and begins using it, one can easily play with the numbers to make them work. For example, let's say that NEM looks like a great short right now, but that the exit is really $31, not $30.68. Now, one could stretch the target to $25 even though the support lies at $26 in order to justify the trade, but the trader inside you knows this is not the case. When setting support and resistance points, one has to realize that if the numbers are fudged, the person fudging the numbers is the one hurt. It's their money that's on the line.

An easy way around the temptation of making the numbers work, is to always look at the support and resistance points first and allow as much slack in the numbers as makes sense. Now, plug in the entry price. Does the risk/reward make sense? If it doesn't change the entry price, not the stop or target prices. Jiggle the entry price to the point where it makes sense and then simply wait until you get that entry point or pass the trade up. There are always more fish in the pond.

Once a number of potential trades are identified, the next step is to take a position in the trade. It is important to realize that no trade is a certainty as they are all probability based. The likelihood of success and failure can be quantified to some degree based on certain risk factors. By quantifying the risk factors and ranking the potential trades based on these risk factors, one can take a systematic approach to trading ... an approach that can pay huge dividends. This is a laborious process that takes time and organization. The simplest way to organize this is via a spreadsheet. Since spreadsheets can contain simple arithmetic equations, you can easily build equations to compute the risk factors described below. When first experimenting with trade rankings, one should error on the side of simplicity as having too many factors is no better than having any at all.

So how can you begin to construct a ranking system that allows you to increase your reward and reduce your risk? It's not so much difficult as it is tiring. Looking back, you must first screen a large number of stocks and then flip through a large number of charts looking for technical patterns that have potential. The primary technical indicators you are interested in are those that have the highest percentage of success. Edwards and Magee go to great lengths to point out all types of technical trading patterns in their bible of technical trading, Technical Analysis of Stock Trends . The obvious factor when ranking trades is to balance the risk versus the reward with the idea that the higher the reward relative risk to the risk, the higher the probability over time that you will make money. The simplest way to calculate the risk to reward ratio, is to pick an entry price for a given stock and then ask yourself, where would you have to consider exiting the stock if it turns out that you are wrong on the trade. For the reward, you ask yourself the same question but the exit is associated with your having a winning trade. Based on how many shares you intend to trade, you can calculate the amount you will loose and the amount you will win. Don't forget to add in your transaction costs as part of this.

This is the fundamental basis of all ranking systems. From there, you can begin to add other variables such as, how long do you expect to be in the trade. The shorter the period of time relative to the risk/reward, the more money you can make over time (assuming you win more than you lose). As your refine your ranking system you will find that stocks with higher betas are naturally more susceptible to short trading periods given their volatility.

Another key variable is a confidence factor. The confidence factor itself if typically based on several factors such as the probability that the technical picture is favourable, the probability of the market contributing to your individual stocks success. Regardless of the factors you experiment with, it is important that you keep your data available for study over time so that you can continue to refine your system. Without constant scrutiny, your ranking system can loose it's value overtime as the markets are dynamic and always changing.


Embellishing the Formula

Once one has mastered the use of the simplest formula for risk/reward, one can consider embellishing the formula to include other criteria. For example, if one could reasonably judge the amount of time it takes a trade to play out, then that knowledge could be incorporated into the spreadsheet in order to rank the trades on a more favourable basis. Think about it. There is only so much capital to use when trading. Using that capital on the highest potential return over some period of time is the desire.

Another key element of gaining the highest potential return on ones money is to associate a confidence factor into the equation based on the stock, the technical pattern being traded, whether the trade is in the direction of short, intermediate and long term trends, etc. Again, there are a number of factors that can be added to the formula to rank the trades and use that ranking as a basis for decision making. The desire is to remove some of the gut feeling that goes into trading with a more logical and less emotional process.

Analyzing the Results

Another advantage of plugging numbers into a spreadsheet s that one than then have a historical accounting of trades taken be they successful or not. Keeping ones historical data allows later analysis of that data in order to improve ones performance in the future.

For example, examining historical data to determine where the largest losses were and then deciding if they were because of failed stop exits could provide fruitful insight to changing trading behaviours. The same is true for wins.

Another exercise would be to look over the charts a month after the trade and examine other data points for exits (both success and fail exits). In doing this, one could speculate on what if scenarios such as, "What if I had maintained the position longer. Would it had continued to perform or would it have turned into a bust?". The imagination can run wild with such scenarios and if you are like most, the amount of time available to ones research is limited to the minimum analysis of old trade data, but there is value in it. It has been said that if mankind doesn't understand the mistakes of the past then we are doomed to repeat those mistakes in the future. Dwelling on the past is not the issue, but learning from it does have benefit. The game of trading is a lonely game. In today's world it is, for the most part, a game of solitaire where individuals from all walks of life stare endlessly at flickering screens while moving piles of money around. One has to show the motivation to sharpen their game as no one else will. As we all know, if one is not on top of your game, at least in this game, one doesn't last long.


Summary

Always calculate your risk to reward ratio prior to making a trade. Refuse potential trades unless the risk to reward ratio is 1:2, that is for every dollar risk, there is a potential for two dollars in return. By calculating your risk to reward for every trade you will ignore marginal trades and you will identify your exit points before taking a trade. Recognize that you want to understand your exit criteria ... at the beginning of the trade, not sometime later. Once you are comfortable with simple risk to reward measurements and are identifying support and resistance zones reasonably accurately, you can consider increasing the complexity of your formula to consider other variables such as time and confidence. Lastly, keep your data points and analyze your successes and failures over time in order to hone your trading strategy.


Article written by Technical Analysis Today - www.tatoday.com


http://www.otrader.com.au/stock_and_option_trading_articles/risk_to_reward_ratios.asp

Money management rules for stock trading

Money management rules are an obvious part of every good stock trading strategy.

These rules should answer these questions:

• How big is my risk for one trade ?
• How many opened trades I can have at a time ?
• What is my risk:reward ratio ?
• and other important issues

These money management rules will help you to identify how many shares you can buy or sell short in a particular trade.

How big is my risk for one trade ?

The definition of maximal risk value for one trade could vary a little bit. Generally, the numbers used are between 0.5% to 2% of the total account size.

Example:
The account size is $100,000 USD. The maximum risk per trade is 1%. It means that you can risk $1000 USD on every trade. If distance between your entry and stop-loss level is $1 USD, then you know that you can open trade with 1000 shares. Simply calculated by (absolute risk)/ (point of distance between entry and stop-loss level).

Should you open trade with 1000 shares? No! You must check other money management rules and combine the results.

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My stock market trading tip:

If you are a beginner in trading, start with a small risk. Use 0.4% or 0.5% risk of the total account value. And as your confidence grows and your trading journal reports your success, increase it.

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How many opened trades I can have at a time ?

It isn’t easy to manage trades by moving stop or taking profits manually if you have a lot of trades and only two hands! You must be able to manage trades manually in case of any strong move on the stock markets. Even if your trades are not day trades but you are swing trading on stock markets, it can happen. So every trader must limit the maximum number of opened trades. The absolute maximum for a single person is eight open trades at once. Don’t surpass this hard limit.

Five or six open trades at once as a maximum is an appropriate limit for every trader.

Example:
Your swing stock trading account size is $100,000 USD. You decided to have max. five open trades at once. Your broker provides you with a 2:1 overnight margin. That means you can use $40,000 USD for one trade. How was it calculated? 100,000 x 2/5 = $40,000. So when you plan to buy XYZ stock with a stock price of $20 USD, this rule tells you that you can buy max. 2000 shares. Combine it with the number of shares from the previous rule and use the LOWER value for your trade setup.

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Special stock market trading tip:

During the first years of your trading set this number of trades to the lower value (like 3 or 4 max.)

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What is my risk: reward ratio ?

Never, ever try to have the risk reward ratio less then 2.5 to 1. This rule is crucial in your trading statistics, especially if you’re new to trading and without any relevant trade history, so set this ratio to 3:1.

Other relevant issues

There are also other important rules, which are part of a stock trading strategy.

Trade only liquid stocks. stocks have an average daily trading volumeover 300,000 shares traded per day (for swing trading stock) or above 1,000,000 shares per day (for online day trading).

Trade stocks with a price above $5 USD. Stocks with a low price aren’t traded by big institutional traders and therefore are easily manipulated. Technical analysis can fail on such stocks. Also, most big investment funds don’t invest in such low-priced stocks.

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Another of my tips on stock market trading:

All money management rules can be easily defined in spreadsheet (like Excel or OpenOffice Calc) and then all values are calculated automatically as you are entering your setup entry , stop-loss and targets .

Here is example of a spreadsheet table:

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http://www.simple-stock-trading.com/moneymanagement.html

Risk reward ratio

Risk reward ratio is a very important definition. Every trader must have this value set in his stock trading strategy This simple formula is a little stock trading secret. It helps you to move trading probabilities in your favor.

The profit value for every trade setup must be at least three times bigger than the risk value. 

Simply put, if you expect to make a profit of $3 USD per share in a trade, you have to risk $1 USD per share as maximum.

This trading secret looks easy, but a lot of traders break this rule, and then their trading results are bad.

When you trade only trades with the potential profit of $3 or more times bigger than the taken risk, your result will be stock trading with regular monthly income.

Later, as you develop a longer history of your real trades, you’ll be able to make small modifications of this ratio to value that best fit your trading strategy. Your trading journal or trade accounting software will provide you enough reports to do it.

It’s an easy to check if your trade setup fits with your risk/reward ratio. Simply use a spreadsheet with formulas.

Example how to use spreadsheet for your risk/reward ratio calculation is described on money management page.

My special stock market trading tip

Don’t be afraid to reject a trade setup even you like it very much.

There are plenty of other trade opportunities. You can find good stock picks on the stock market every day

Check this ratio during trade development

I have described above how to use risk reward ratio when you prepare stock trading setup for your stock trading strategy. But it is not last time you use these formulas.

You have to use this ratio also during trade management process. As you have trade already opened, you have to manage it accordingly. It means that you must trail stop loss level based on your trailing stop rules and also you must take profits.

Risk reward ratio is used when you think about new trailing stop level. It is always good to have this ratio better then 1:1 as your trade is developing and you want to trail stop.

As your trade is closer and closer to your expected target, trail stop to have risk smaller then possible profit. Always check this ratio when you do regular trade analysis during your daily trading and analysis routine.

http://www.simple-stock-trading.com/riskrewardratio.html

Know your Risk: The Risk-Reward Ratio

Know your Risk: The Risk-Reward Ratio

Risk is a part of trading. Every trade carries a certain level of risk. Every trader must know the amount of risk that is being assumed on each trade. Knowing the amount of risk on each trade is one way to limit it and to protect your trading account. The best way to know your risk is to determine the risk-reward ratio. It is one of the most effective risk management tools used in trading.

The risk-reward ratio is a parameter that helps a trader to determine the level of risk in a trade. It shows how much a trader is risking versus the potential reward (or profit) on a trade. While this may seem simplistic, many traders neglect taking this step and often find that their losses are very large.


How to Determine the Risk-Reward Ratio?

The first step is to determine the amount of risk. This can be determined by the amount of money needed to enter the trade. The cost of the currency multiplied times the number of lots will help the trader to know how much money is actually at risk in the trade. The first number in the ratio is the amount of risk in the trade.

The reward is the gain in the currency price that the trader is hoping to earn from the currency price movement. This gain multiplied times the number of lots traded is the potential reward. The second number in the ratio is the potential reward (or profit) of the trade.

Examples

Here are a few examples of the risk-reward ratio:

If the risk is $200 and the reward is $400, then the risk-reward ratio is 200:400 or 1:2.
If the risk is $500 and the reward it $1,500, then the risk-reward ratio is 500:1500 or 1:3.
If the risk is $1,000 and the reward is $500, then the risk-reward ratio is 1000:500 or 2:1.

What is a Good Risk-Reward Ratio?

The minimum risk-reward ratio for a Forex trade is 1:2. However, a larger ratio is better. An acceptable risk-reward ratio for beginning traders is 1:3. Any number below 1:3 is too risky so the trade should be avoided. Never enter a trade in which the risk-reward ratio is 1:1 or the risk outweighs the reward.

Many experienced trader will only enter trades in which the risk-reward ratio is 1:5 or higher. This requires that the trader wait for a trade with this ratio, but the reward is worth it. A higher risk-reward ratio is a good idea in case the currency does not make the anticipated price movement. However, if the trader uses a lower risk-reward ratio, there is very little room for smaller price movements and the amount of risk will increase.

The risk-reward ratio is an important risk management and trading tool. It is important for beginning traders to take the extra time to perform this task because it can help to minimize risk in every trade. Waiting for the right risk-reward ratio can take a long time. However, the benefits of waiting for a higher risk-reward ratio are worth the effort and patience. You will know your risk and know your potential profit. Most importantly, you will know whether the trade is worthy of your money.


The Risk-Reward Ratio
By John Russell, About.com Guide
http://forextrading.about.com/od/basicforexrisks/a/riskreward_ro.htm

Risk/Reward Ratio

What Does Risk/Reward Ratio Mean?
A ratio used by many investors to compare the expected returns of an investment to the amount of risk undertaken to capture these returns. This ratio is calculated mathematically by dividing the amount of profit the trader expects to have made when the position is closed (i.e. the reward) by the amount he or she stands to lose if price moves in the unexpected direction (i.e. the risk).

Investopedia explains Risk/Reward Ratio
Let's say a trader purchases 100 shares of XYZ Company at $20 and places a stop-loss order at $15 to ensure that her losses will not exceed $500. Let's also assume that this trader believes that the price of XYZ will reach $30 in the next few months. In this case, the trader is willing to risk $5 per share to make an expected return of $10 per share after closing her position. Since the trader stands to make double the amount that she has risked, she would be said to have a 2:1 risk/reward ratio on that particular trade. The optimal risk/reward ratio differs widely among trading strategies. Some trial and error is usually required to determine which ratio is best for a given trading strategy.

 http://www.investopedia.com/terms/r/riskrewardratio.asp#ixzz1eaycfwSK