If you haven’t realized by now, trading is very risky at times. It is extremely important to develop a strong and consistent safety net, in order to prevent you from gambling and push you towards actual trading based on facts and figures. Trading without safety nets is one of the leading contributors for people losing their money. Most of the time, beginners simply don’t know what they’re doing. With the proper management and skill set, trading can be very profitable but only if you take the necessary precautions.
One of the most important things to consider before you start trading is your R/R, or risk/reward ratio. This will determine how much you should invest on any one trade at any one time.
The ability to safely manage risk is a leading factor in how successful you will be as a trader, as well as the ability to calculate a good risk/reward ratio for each trade. To break it down, imagine for a second that a good friend had asked to borrow $25 from you, and offered to pay you back $30 in two weeks. You might think to yourself that is isn’t worth the risk, but what if they said they would pay you back $50 instead? The risk of losing $25 to make $30 might sounds rather off-putting but the opportunity to make $50 might sound much more appealing. When it comes to trading, you have to take into account how much of your capital you are risking, and how much you stand to make.
Let us look at an example of a financial instrument to give a better understanding of how proper risk/reward ratio can greatly improve your trading outcome. Let’s say that you have looked at some of the upcoming stocks which you believe will rise in the near future, and you have select company A which is currently valued at $10 a share, and you think it has the potential to rise to $15 a share, where you will exit the position.
Your account size stands at $1000, and you elect to use $500 towards the investment. After doing all your research on the company, you decide to buy 50 shares at $10 each, but do you actually know how to calculate your risk/reward ratio and incorporate it into your trade?
To calculate your risk/reward ratio is very easy. All you have to do is divide your reward by the price of your maximum risk. So going back to company A, if the stock rises to $15 per share, you would make $5 for each of your 50 shares for a total of $250. Since you paid $500 for the investment, you would divide 250 by 500 which gives you a result of 0.5, which means that your overall risk/reward ratio for this trade 0.5:1. So is this a worthwhile trade, or should you stay away from it? Just because you are risking $500 on this trade does not mean that you should let it shrink all the way to nothing. Every trader should have a stop loss or some way to limit the overall risk that they are exposed too.
For this trade, let’s say we set our stop loss at $7 and once this price reaches this stop loss order you immediately sell the stock and look for another opportunity. However because we had set our stop loss order at $7 we can tinker with the numbers slightly, and adjust our risk/reward ratio.
The profit stays the same, but we are now only risking $150 to make $250. Risk management is one of the most important pillars of successful trading taught at Darby Academy. Without it, you stand to destroy your investments time after time. Before starting to trade, we insist on taking you hand in hand to learn the fundamentals of successful trading, and make the most out of the great potential the markets have to offer.