Tuesday, October 05, 2010
As defined from Investopedia
A ratio used by many investors to compare the expected returns of an investment to the amount of risk undertaken to capture these returns. This ratio is calculated mathematically by dividing the amount of profit the trader expects to have made when the position is closed (i.e. the reward) by the amount he or she stands to lose if price moves in the unexpected direction
Clear as mud, right? Using Risk/Reward Ratio to figure out which stocks to buy will help you get in the stocks with the best setup and grow your account faster.
Let’s take an example from today: BIDU
If we only risk 1% of our total capital on any given trade, that means we can lose $1,000 with a $100,000 account.
BIDU appeared on the Percolator Scan earlier today when it was around $100 per share.To keep things simple our initial stop is at $99. So we are risking $1 for every share we own.
This means we can purchase 1000 shares of BIDU at 1% risk or $100,000 worth. If the stock drops to $99.00 our sell order will trigger for a loss of $1 per share or $1,000 total loss.
Now, let’s assume a target of 10% from your entry; or a stock price of $110 for a gain of $10 per share or $10,000.
Overall, we have a risk reward of 10-1. If the stock follows through and reaches the target, our entire account grew by 10% in a single trade, while only risking $1000 that we would normally risk on any other trade.
As you start using this ratio, you will notice taking setups with more stable price action on the swing back up will offer a better reward. You have to weigh this with how much return you think you can get out of that stock.
Based on your risk tolerance you can add checks in place to make sure only a maximum percent of your account if ever at risk do to a price shock. For instance, in the BIDU case you could have a rule where you only take on a maxmimum of 10% in your account in any trade or $10,000 worth of the stock.
If you are a Bluefin user, Risk Reward is calculated using a 10% target from the current price. The initial stop is set the lowest low in the past three days.