Managing Risk in Every Trade

Whether you are just beginning to trade or are well on your way to achieving your goals, creating a disciplined approach to trading should be an important part of your plan. Following this plan will help you acquire the level of confidence needed to select and stick to your strategy through short-term market fluctuations, and achieve the long-term results you want. An important thing to consider when putting together your plan is your financial and emotional ability to deal with risk. Understanding the level of risk you can tolerate will determine the types of investments you should select for your portfolio.

Risk to Reward Ratio

Many traders believe that success in the market is determined by how often you win. In reality, the big picture is more important than the frequency of winning. For example, how would you feel about winning 99 times out of 100? Most people would be ecstatic about losing only once. However, if you had made $1 on each of the 99 wins, but lost $100 on the single loss, the excitement would quickly dissipate.

In the world of trading, how many times you win or lose is not nearly as important as your risk to reward ratio. Consider your potential risk as compared to your potential reward before you ever decide to purchase a stock. Set your minimum acceptable risk to reward ratio at 1 dollar risk to 2 dollars reward before ever going forward with a trade.

By picking stocks that meet your 1:2 risk to reward ratio, you will be profitable even if only 50% of your trades are winners.

Risk to Reawrd Ratio
For example, if your analysis indicates that the stock could move up $2 before hitting a point where it has shown a pattern of turning around before, but the next support level is $4 below the current price, the risk to reward ratio is unacceptable. You could make $2, but you could lose $4. That ratio needs to be reversed to be considered a "good" risk.