Pick your favorite stock that you would buy at today's price.
What would your stop loss be?
At what price would you want to sell it for a profit?
Now based on your risk vs reward, what is the ratio? 1:1, 2:1, 10:1, etc, write it down so you can compare yourself to what professional traders and billionaires aim for when looking at risk reward.
In this MSFT trade, we bought 2000 shares at $53 and our stop was $52.90 so we are risking $.10 per share. Our first sell was at $53.50, so we sold for around a $.50 profit. What is the average risk reward so far in this trade?
- 1:1 Risk Reward
- 5:1 Risk Reward
- 7:1 Risk Reward
- 8:1 Risk Reward
After you answer this question we will move onto an example on proper risk reward!
You bought the stock you picked today, where would you get out if the trade started to show a loss? If you have a defined stop where you will take a loss if the trade fails? You will limit having the painful, big losses most new traders learn the hard way. By having a stop (which is at a price below your entry) you will sell for a small loss and limit further losses if the stock continues to fall.
By setting a stop loss you are determining your risk in that particular trade to limit your downside. 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 or better. But why? Keep reading and you will find out.
So let's say you are risking $100 in a trade what should be your minimum profit target?
(This is Ray Dalio, a BSD, worth Billions!)
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 followed which was called 5:1, and 5:1 is this:
“If I invest a dollar, I won't part with that dollar I’m investing unless I feel certain I’m 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.
Almost everybody thinks that if you want to get big rewards you need to take huge risks. But if you keep thinking that, you’re going to be broke. Spend some time to really learn this because we will be building off the idea of risk reward in our next lesson "Finding a Bull Flag”.
The correct answer for Question 1 was B 5:1 Risk Reward and Question 2 was also B $500.
Now fill out a new game plan of your favorite stock below with your new knowledge on risk reward and compare the difference between not knowing about proper risk reward vs now with your new found knowledge of it. If your game plan is still the same, you should re read the lesson a few times over.
What is your entry price?
What is your stop?
Why is your stop there?
What is your ideal target price to sell at?
What is the risk reward ratio?
Here are some Definitions to help you understand the major parts of your game plan.
1) "Entry Price" Defined: Based on technical analysis, these are typically levels of support and resistance that, if breached, could potentially lead to momentum in a given direction.
2) "Target Range" Defined: Target range is the price range which the stock could potentially reach, based on your opinion.
3) "Stop-Loss Level" Defined: Level that you could potentially place a stop-loss order on the hypothetical trade in order to manage risk. However, all actual trading decisions are made independent of the information provided here.