One of the key factors that every trader should be managing is risk. Understanding the best and worst case scenarios, and being realistic within those estimates. The fact is that if you want to trade within the stock market, you will always carry some risk with the money you put up. Limiting that risk can mean a world of difference not only to your stress levels, but to the growth of your account.
Risk management is a key factor that is frequently overlooked. While it can be confusing for novice traders to calculate their risk/reward ratio, over time your assessment will become part of your trading, and each trade will become much easier and faster for you to measure.
While this write-up won’t touch on every aspect or strategy of risk management (there are many), it will address some of the basics, and will hopefully bring some of the risk/reward setups that you’re prepared to trade to your attention.
Determine Your Risk
How much are you willing to lose? Obviously, risk varies greatly across the spectrum of traders. Some insist on a 1% or 2% max pain level. Others thrive on it, and add to better position themselves (increasing their risk level with each add). Regardless of how you choose to trade at any given time, you should always establish a risk level (max pain/loss). You can then use that risk level to determine appropriate size for the trade.
Let’s run through a few examples…
Let’s say for grins that you’re looking at buying $PTCT, which currently trades at $10.21 per share. You’ve determined that the maximum you are willing to lose on this trade (your max pain), is $500. If $10,000 is the max you are willing to invest with a $500 risk level, you could afford to pick up 979 shares. While holding that 979 shares, based on your max risk level of $500, you would have to sell or stop out at $9.70. ($500 max pain/979 shares = $.51 = risk level of $9.70 on the chart)
Let’s take a look…
$PTCT is forming what appears to be a descending broadening wedge on the daily, with a large open gap still above to be filled at some point. After noticing that the pattern is basing, you want to enter long, but instead of establishing a target the old-fashioned way, you want to get technical and have a specific level in mind. Let’s look at it closer…
While $PTCT is trading at $10.21 per share, you can easily figure out your appropriate share size (based on your max pain of $500 from above). If you only buy as many shares as the formula allows, you will have the lee way to allow for that risk level before you hit your max loss of $500. Further examples and breakdowns are on the chart below:
Very overlooked, and very basic. There are many reasons why novice traders lose money, but one of the big ones comes from their inability to manage their risk. Investing any amount of money into the market comes with it’s share of risk. If you’re going to risk it, shouldn’t the amount of money that you stand to gain be more?
Let’s say you’ve got a ticker in mind for a trade. Since we’re already into $PTCT, let’s roll with that one. We already did the math on max pain… but do you know the risk/reward ratio?
While we’ve already established our risk levels on if the trade goes against us, what do we stand to make if it goes our way? Is it even a good trade to take? A risk reward ratio of 1:1 is risking as much as you stand to make. Most experienced traders won’t even touch a trade until they see at least a 2:1 ratio, or an opportunity to double their total risk. 3:1 would be 3 times your risk, 4:1 would be 4 times, and so on. It’s a basic calculation, and the numbers don’t ever lie.
Lets say you expect $PTCT to make a touch on the resistance line of the descending wedge. Using those same max pain levels from before, we can establish our risk/reward ratios for each trade and risk level. In this example, you can easily see that each risk/reward ratio is well over 1 (1:1), with the lowest stop loss and ration being 2.12 (or 2.12:1 risk). Looking at the example below, it’s obvious the best risk/reward trade is with the 9.90 stop, which yeilds a 10.94 ration (nearly an 11:1 reward on our risk).
I want to be clear on one thing… risk/reward gives no indication of a probable outcome. While risk/reward certainly limits your losses, it won’t guarantee your wins. Playing the lottery for example, and risking the same amount of money to gain millions would be a much better investment on a risk/reward ratio than trading with it in the market, but carries with it a far less chance of a probable outcome. Enter what you believe to probable trades with generous risk/reward ratios.
Basic Risk/Reward Calcuation
Risk/reward calculation is easy, and something you should analyze before entering a trade. Just divide your net profit (total potential reward) by your max pain (total potential loss). Using the $PTCT example above, if you bought 500 shares, and it hit your target, you’d stand to make $3.39 per share (or $1695). On the flip side, your downside risk (on the 9.90 level stop) is only $.31 (or $155 on your 500 shares). So you can either divide the $3.39 upside by the $.31 downside, or the $1695 by the 155.
$3.39/$.31 = 10.94
$1695/$155 = 10.94
Both result in a risk/reward ratio of 10.94:1. From a risk/reward perspective, thats’ a great trade idea. Now, do you feel it’s probable?
Risk management isn’t the most appealing aspect of trading. It usually isn’t until after months of losing money and enduring countless frustrations that traders begin to focus on this aspect of trading.
While it may be much easier to focus on the potential of enormous upsides, the potential downsides need some of your focus as well. By practicing efficient risk management, you will limit this downside, while still leaving the door wide open for the bigger moves in your favor.