Original article published on 5/2/2016
What is this all about and why is it important? Unless your are EXTREMELY good at picking solid companies and have the patience level similar to that of Warren Buffett to hold for decades and decades; trading requires you to be governed by rules.
I outlined some in my "methodology" piece and make no mistake, these rules are set in place as defense against the markets' unknowns. Which, after a decade of trading, is quite a lot.
I am not sure where you are in your trading journey but one thing I hope you gather soon enough (before blowing up any accounts) is that your success as a trader will rise and fall with your rules and your adherence to them.
Without making it too complex, in addition to the rules I have outlined in my methodology; I always ensure that the Reward I seek on a trade, far outweighs the Risk!
There are different ways to view this but I look at it like this:
Risk Vs. Reward
While there are consistently profitable traders in the market, no one can say or “predict” where the market or a particular security is going with any certainty. Do not let the masses fool you; there is no crystal ball. This is why it’s essential to not only have a trading plan where you focus on “Risk Management” but also one to ensure that the “Risk” you’re taking on, doesn’t over shadow the “Reward”. If you’re a fairly seasoned trader this (hopefully) is common knowledge and a part of your “methodology”. For those of you now starting out, this is essential to calculate before investing in any security. You want the reward to outweigh the risk. That means, for every $1 of risk you take on for a trade, you want to ensure the reward is more than that. Simply put, if you’re buying a stock; the reward for a $1 risk should be $2 or more. The better the risk/reward, the more favorable of a trade it becomes.
I buy 1000 shares of corporation “KEL” for $5 dollars each. 1000 x $5= $5000. I have already identified my entry and exit, so I know if I am wrong on this trade; I will exit the stock at 4.50. 1000 x $4.50= $4500. My loss on the trade would be $500. However, if I am right; I would exit my trade somewhere around 7. 1000 x $7= $7000. A difference of +$2000. In that example, I am willing to lose $500 to make $2000. A risk/reward of 1 vs. 4.
Hope that example helped simplify the concept of risk vs. reward.