Managing Risk & Reward
Updated: Sep 22, 2022
Managing your risk vs. reward is the key to longevity in the market. This plan should be done before a trade is ever placed. "One of the biggest risks in trading is not knowing the limitations of your own tactics. If you hold losses, then big losses can blow you up. If you cut losses short, then a series of small losses can blow you up. Every trader must have a protection plan against his own nature." - Mark Minervini
The chart to the right shows breakeven win rate % needed for different Risk/Reward ratios. This chart though it seems simple is often misunderstood and/or not utilized enough by many traders. The breakeven win rate % is the percentage of times you would need a setup to hit your target to breakeven. If you risk $2 for every $1 you stand to gain, you will need to predict price correctly 67% of the time. I personally stick to 1:2 risk/reward so I will never take a trade that rewards less than $2 for every $1 of risk I have. In my case, I need to hit 33% of my setups to be a profitable trader.
Risk is defined as your stop on how much money you are willing to lose. This stop can be manual or mental however many traders that use mental stops will find a way out of needing to get out of the trade. This is not the best practice. Having your plan built ahead of time is the key to success. For my style I like to see a close above/below my stop in order to get stopped out however this also depends on the market conditions and the personality of the stock (something I'll dive into with a later post). It is also very important to understand the difference in losses and gains. If you lose 50% of your portfolio, you need a 100% return to recoup that loss. If you lose 75%, you need a 300% return to breakeven. This is why the greatest traders in the world primarily focus on their risk on the table. If a few losses can put you out of the game, it is time to reevaluate how you manage your risk. Find which risk/reward ratio suits you best based on your previous trades or by paper trading using different ratios. Have a plan before you enter a trade and commit.