Reward to Risk Explained – Pt2
In part 1 of the Reward to Risk series I covered what “risk” is and the 3 components you need to calculate your reward to risk ratio. In this article you will learn how we’re going to calculate this multiple. The risk, in this context is simply the difference between your entry price and your stop loss price. So, if your entry was $20.00 and your stop loss is $19.00, you have a total of $1.00 at risk. Your reward is the difference between your entry price and your target price. So, again, if the entry was $20.00 and the target was $25.00, your potential reward would be $5.00. In this case, we have a 5:1 reward to risk multiple.
Earlier we discussed how you can’t just set your target by using a multiple of three times your risk, because that will set an unrealistic target price. It’s sort of a backwards way of doing things. The proper way to set your target is to use previous areas of support and resistance. Now, on this chart, you can clearly see areas of new highs that now act as resistance points. So these areas become excellent targets to set. On the next chart $93.00 would’ve been a good target area, at least for the first half of the trade.
Looking at another example, you clearly see three red boxes for potential future resistance areas. The stock does break out and in all three occasions at these areas, so all three of these potential entries would have targets somewhere in these boxes, at least for the first half of the trade. If there’s no support and resistance on the chart, the next logical choice is to use the next largest whole numbers. So in this example, 13, 14, 15 and 16, these areas are good areas to set targets because they act as natural resistance points. Many people use their stop losses and their targets in the same areas and so that’s why these areas are very strong.
Look at this chart we can clearly see whole numbers acting as resistance, here at 21, 23 and on 3 separate occasions at 27, the whole number acted as a resistance point. Setting targets at whole number, whether it be 25, 26, in this case 27 is where the resistance actually occurred. Now if you had more than one target, the best method is to average them out. If target 1 was $6.00 away, and target 2 was $3.00, target 3 was $1.00; you can simply add those up and divide them by 3, that will give you a target of $3.00. As long as your risk was 1 or less, you have the necessary 3:1 ratio that you require.
What else do you need to consider when you’re calculating your reward to risk? Well the first thing is you need to know your actual average winner compared to your actual average loser. What exactly is that? Well if you add up the total results of your winners and divide it by the number of winning trades you have, that will tell you how much you win on average. It’s quite simple. If you make $500.00, $600.00, $1,000.00 and $1,500.00, you add the altogether and divide them by the number of winners and you’ll know how much you win on average. The same applies for your average losers. You add up the totals of how much you lose in all your trades and divide it by the number of losing trades you have and you’ll know exactly how much you lose on average.
These numbers are important because now you need to know how that compares to your intended reward to risk. Remember, we discussed this before. If you only make $1.50 instead of the $3.00 you were expecting then you’re fooling yourself into thinking you have a good reward to risk ratio. Another example we see here, if you have $4.25 and risk $2.35, you now have a reward to risk ratio of 3.15 and then you need to ask if that fits into your trading plan. I recommend 3 or higher, but you might use a multiple of 4 or higher. It really depends on what you use in your trading plan.
The third point is, are you able to maintain a high reward to risk multiple and a high winning percentage? It really is a balancing act between the two. I’d recommend 3 or higher for a reward multiple and a 40 percent win percentage. I will show you the numbers in a moment how, but if you can maintain those figures, you’ll be very successful. You need to focus as much attention on both of these as you can and keep them as high as you as possible. In part 3 of the reward to risk series I will cover the “nitty gritty” math behind the formula and how you winning percentage and reward multiple work in tandem to maximize your results.