For those who don’t know, I’m all about properly managing my risk.
You see, I wasn’t always a trader… in fact, I didn’t start trading until the age of 50, after my broker lost 50% of my money.
Once I realized they weren’t treating my account with the care it needed… I took matters into my own hands.
Thereafter, I came up with clear rules for trading, like my 2% rule – I never risk more than 2% of my account on any one trade… and developed a simple-to-follow approach to generate consistent profits.
Now, my strengths are in timing my entries and exits to near perfection and developing plans for multiple scenarios.
You see, I like to weigh the risk and reward before I get into a trade… and I look for low-risk, high-reward setups.
You might think it’s difficult at first… knowing exactly how much you’re risking and how much you’ll get rewarded with off the bat.
But it’s really not, especially when you have a plan in place.
For example, I send out trading plans for my best setups to my clients… I write down exactly where I’m looking to get in, where I’ll stop out in case things get sour, and spots where I’m looking to take profits.
Additionally, I’ll add comments about what the pattern in the stock is.
Here’s a look at the daily chart I was watching in Tetra Tech Inc. (TTEK).
Basically, in the blue encircled area, that’s where I spotted the bullish setup. Now, I was monitoring this stock and looking for a clear entry.
Now, the buy zone is between $71.91 to $72.57.
The stop loss area is $70.38, and the first target is $73.74 and the second target is $74.87.
You actually could’ve bought the stock within that area. Let’s say you were able to pick up some shares at $72.00.
Well, you’re risking about 2.25% on the trade here. Remember, we never want to risk more than 2% of our account on a trade… but that doesn’t mean our stop loss prices on our trades can’t be more than 2% from our entry (it all has to do with position sizing, which I teach to my clients).
Now, on the upside… you’re looking to make 2.42% on the first piece, and around 4% on the
Second piece… then monitor the moving averages on the daily chart after.
That said, off the bat, you’re looking at at least a 1 to 1.42 risk-reward. The simple way to calculate this is just taking the average of the target percentages and dividing that by the risk percentage.
So here, we would do (2.42% + 4%) / 2. You get 3.21%, then you divide that by 2.25%.
Now, since we’re monitoring technicals with this one it can be a little tricky. However, you could easily just use those two profit targets, and sell the first half for 2.42%… and the second half for ~4%.
Another way, you could’ve actually planned the trade a different way, and look to sell ⅓ of your position at $73.74, the next ⅓ at $74.87, then the rest for a 10% move… moving your stop higher along the way so you don’t give back any profits.
Well, if you used that plan… and stuck with it… here’s what would’ve happened.
Well, to calculate the risk-reward ratio for that plan, you would find the average of the target percentage profits, which is (2.42% + 4% + 10%) / 3, or 5.47. Then you would take 5.47 and divide it by 2.25.
That said, the risk-reward would be 1 to 2.43. In other words, for every percentage point of risk you take… you’re looking to make 2.43%.
Why is this important?
Well, you never want to have a risk-reward that’s 1-1 or below 1-1. In other words, you always want to make more than you risk.
For example, if you’re a 50-50 trader, then trading stocks with a 1-1 risk-reward ratio doesn’t make sense. You see, if you win only half the time and take trades where you risk a dollar to make a dollar, you’ll just get eaten up by the fees.
Additionally, if you have a risk-reward of 1 to anything below 1, you’re not managing your risk properly. For example, if you have a risk-reward of 1 to 0.75, that means you’re risking more than you’re rewarding yourself. In other words, for every $1 of risk you take… you’re only rewarding yourself with 75 cents.
When you understand risk-reward, you’re actually able to manage your risk better… and it all starts with planning your trades, as well as having a consistently profitable, simple-to-follow strategy.
If you’d like to learn more about my trading rules, trading ideas and start receiving real-time trade alerts, then I encourage you to join my service.