Reward:Risk Ratio
Assessing a Trades Potential
When looking at a stock to buy, we look to various tools and techniques to
help us assess the probability of its upward movement. However, will it go up
is not the only question to ask - we also need to analyze the chart to see how
far it is likely to go up and also how much of a loss we are willing to
take to allow it to reach it's profit potential. The potential profit of a
trade divided by the potential loss of trade is known as the Reward:Risk
Ratio.
Our first chart of PCG
shows the stock near a trendline on an upward trending channel. We will set
our entry price at 21.4. How far will this trade move to the upside? The
channel tells us that it should move to the upper channel line, so we can set
our target at 23.50. We have our reward measurement of 2.1.
Now we need to calculate
risk. How far of a drawdown will we allow before we exit this trade? An even
better question is "At what point is our reason for entering this trade
no longer valid?" Since we are entering the trade based on the reversal
off the lower trendline, we can use this to set our initial stop. If price
reverses after hitting our entry price, we would say that 20.75 would be a
sufficient move to break the trendline, and that stop gives us a risk of .65.
Our potential reward is
2.1 and our potential loss is .65. So, our Reward:Risk ratio is 3.23. Any
Reward:Risk ratio of 3 or above is considered very good, and we are looking
at a good candidate based on this calculation.
Reward:Risk Ratio: PP/PL
(PP=Potential Profit and PL=Potential Loss)
The most common mistake
made when assessing the Reward:Risk Ratio is setting the target price where
we hope the security goes, not where we can realistically expect it to go. It
is imperative when calculating Reward:Risk that we are realistic about our
levels. Dreamers beware, because cheating on this calculation is of no
benefit.
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