You just bought your most favorite stock today, your happy but now what?
Everyone excepts that stock is going to rise due to all the work you put in but what happens if that is not the case? What if the stock only continued to fall?
Where would you get out if the stock started to show a loss? If you have a defined out where you will take a loss if the trade fails, you will limit having those painful big losses most new traders learn the hard way.
By having a stop, which is a price below your entry that you will sell for a loss if it gets down there. To cut your loss short and limit further losses and preserve your capital.
So you are determining your risk to limit your losses. By defining your max loss you are willing to take on your investment, you can now figure out the ideal profit! You want to focus on taking trades where you can make 5:1 on your risk.
If you are risking $100 in a trade that you want to strive to make at least $500 in that trade!
If you can strive to aim for 5:1 risk reward or greater you will have a better chance at being successful. Why do we say this? Well let’s hear from Ray Dalio, one of the most successful hedge fund managers of the last century.
“The average person goes out and invests a dollar hoping to make 10% or 20%, if they’re lucky — so if they’re wrong they’re in the hole majorly. Paul Tudor Jones had a principle he used to use called 5:1. And 5:1 is this: If he invests a dollar, he doesn’t part with that dollar he’s investing unless he feels certain he’s going to make five. He knows — he’s not stupid — he knows he’s going to be wrong [sometimes] so if he loses a dollar and has to spend another dollar, spending two to make five, he’s still up $3. He can be wrong four out of five times and still be in great shape.
Most everybody thinks that if I want to get big rewards I need to take huge risks. But if you keep thinking that, you’re gonna be broke.”
Focus on 5:1 risk reward or better!