This post shows you how to calculate your risk/reward properly. Most investors have no clue how to use risk/reward ratios correctly or even worse, they focus only on win/loss ratios and ignore risk/reward at all. A lot of investors have win rates of more than 50%, but they still lose money. If your trades aren’t profitable, it’s likely because your risk/reward ratio is not working.
Here is my tip how to fix this problem:
1. The risk/reward ratio is the profit potential of a trade relative to its loss potential (e.g. doubling your money with a stock or winning millions in the lottery).
2. It is important to understand that risk/reward is not the same as probability (the probability of doubling your money with a stock could be high but winning millions in a lottery is minimal).
3. To calculate risk/reward, you divide your net profit by the price of your maximum risk. (if you have a stop loss order in the market for the stock you invested in, the current price difference to the stop loss price is your loss. With the lottery ticket you can lose all)
4. Never Change the target price in order to achieve a more favourable risk/reward ratio. This is a losing strategy!
Start using this method to calculate risk/reward:
1. Choose a stock based on your research method
2. Set the upside and downside limits based on the entry price (incl. stop losses)
3. Calculate the risk/reward (potential profit/potential loss)
4. If your risk/reward ratio is below your threshold, increase your downside target
5. If you can’t achieve the ratio you want, pick a different stock
Look for trades that suit their risk/reward profile. The more thorough you are with your research, the better your odds are of trading profitably. Sometimes the upside target will change depending on events as you’re holding a stock. If this changes your risk/reward outside of your comfort zone, don’t hesitate to exit the trade. Use your risk/reward calculation to your advantage.
Sven Franssen