January 11, 2008 at 8:59 am | | Comments 1

Practical Risk vs. Reward

A close friend of mine began trading a few months ago, and in his first days we had a discussion about some things he needed clarification on. We discussed order types and stop losses and why chart patterns tend to repeat themselves, but then he asked this question:

“So, if I buy 100 shares of XYZ at $25 per share, I’ll have $2500 at risk?”

My answer was no.

I do have a calculator, so I am aware that the cost of 100 shares of a $25 stock would be $2500, but when considering what is truly at risk, it all depends on your exit strategy.

If you’re willing to hold XYZ until the bitter end and that company goes to $0, then yes the risk is the full amount. But if you’re a trader, your true risk is really limited to how much room you’re going to give the stock. With a prudent stop loss in place of, say, $24, your “risk” on the trade is only $100.

Taking the conversation to the next step, we have to consider only those trades which we feel will offer us a profit amount which is a multiple of our true risk. If you knew you might lose $100 on a given setup but might stand to make several times that, maybe $400, wouldn’t you take that trade? Absolutely. On the other hand, if you were putting $100 at risk and you felt the potential reward was only $100, would you still take the trade? I wouldn’t think so – you’d head for the blackjack tables in Vegas because their bets pay even money and the lights are prettier!

The point is this: weigh your true risk in every trade you consider taking, and only enter that position if the reward is substantial enough to justify putting your money on the line. Only take trades which offer you a lot more if you’re right than they will cost you if you’re wrong. That’s how you protect the downside.

It’ll keep you in the game and help you grow your trading account. 😉

Jeff White
President, The Stock Bandit, Inc.
Swing Trading & Day Trading Service

[tags]Stock Market, Day Trading, Stock Trading, Investing, Swing Trading[/tags]

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  1. Good point. Buying on margin also affects risk.

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