Risk & Reward: Why It's Important.
What is risk/reward?
Risk / Reward is one of the most overlooked variables of trading. Why is this so? Because it requires math. Some traders just simply don't want to do the math, but unfortunately - that's what this game requires. It requires a proper understanding of what you're willing to risk and what you can potentially gain with that risk. With proper risk/reward you can lose most of your trades and still come out profitable <- this is the key advantage to having proper Risk/Reward in a place where you can be wrong many, many times.
How Can I apply Risk/reward?
Applying Risk/Reward requires you to take necessary steps before each trade to determine whether or not the trade you are looking at pertains to your risk/reward strategies.
EX: I need at least 1 to 3 for my risk to reward ratio. For every $1 I risk, there needs to be potential for $3 in winnings.
(I'm long AMD @ $13.10 with my stop @ $12.99, I'm risking 11 cents for 33 cents since my PT is $13.43)
The two primary steps include setting your immediate stop loss whether mental or hard once you are in the trade and sizing the correct amount of shares you own into the trade in order to meet this max loss and not go over.
How Can I Calculate Potential Risk?
Simple. By finding normal levels of support through your own technical analysis and readings of market depth and understanding where that major support level is. Then find the price in which you'd want to enter and subtract the difference in price. Once you know the difference, size your share amount according to how much you are willing to risk.
EX: I see major support @ $0.99 for this stock, and I'm planning to get in @ $1.03. The max I'm willing to risk is $200 so I'd go in with 5K shares.
(5K shares -$0.04/share if stopped out is -$200)
How Can I Calculate Potential Reward?
By utilizing the same technical analysis strategies, knowledge of share structure and market depth to determine where you would want to take profits. At some point, price will meet a dead-end and it's best to take profit before that high is made and the stock comes back down.
EX: I see major resistance @ $1.30 for XYZ, but it looks like smooth sailing from $1.03 - $1.29. I'm in @ $1.03, so my potential reward is $0.26/share but obviously I'd be willing to take profit beforehand if necessary. On 5K shares that's $1300 potential reward. (5K shares $0.26/share = $1300 Profit)
Proper Sizing when applying risk/reward strategies
Now that you have determined your risk before each trade - it's easy to size in accordingly. Just remember that losing 50% on 2% of your account is a lot less painful than 50% on 100% of your account. So if your risk happens to be 50%, obviously don't go in with 100% of your account. a 50% loss on 2% of your account only requires a 50% gain on 2% of your account to recover. Whereas a 50% loss on 100% of your account would require a 100% gain on your remainder capital to recover.
Good Risk/Reward Set Up Example
Here you can see that with VWAP being defined as my level of risk on this short, I'm only risking about $1 or less. (VWAP was never tested the entire day) In hindsight, you can see that there was $5/share reward potential from where I shorted with my risk level never being met. This is a good trade.
Bad Risk/Reward Set Up Example
Here you can see that buying into this overextended mover that's showing profit may have already been taken with the given volume circumstances, max gain potential here is probably HOD, whereas the loss potential is unending on small cap stocks like this if held long term. In fact, I've met many traders that have experienced this kind of risk through holding too long.