Trading Basics: Evolution of a Trader

WHAT WAS THE RISK/REWARD RATIO?

I am not a big fan of the risk/reward ratio, but it seems to be a hit among traders and educators. When I place a stop, I know in advance what my risk is: It is the difference between what I will pay when I buy the stock and the stop (assuming it does not gap lower). What about the reward? There is the rub.

How high will the stock go? Will it soar by three or four times the risk, as many claim a winning trade should? How many times have you thrown away a stock that went on to double because it had less than a 4 to 1 risk/reward ratio (the reward is the first number, by convention)?

That is why I do not care for the risk/reward ratio. I can accurately gauge the loss, but not the reward. However, when setting up a short-term trade like a swing trade where I will pick a price target to sell at, then the ratio is important. I want to maximize my gains for the capital employed. Knowing how much I will make in a swing trade is important information. But for longer trades, I let my profits run and do not concern myself with the risk/reward ratio.

If you are contemplating a trade with defined profit and loss targets and the risk to reward ratio is less than three or four to one, then consider looking elsewhere for another opportunity. The reward is just not high enough to justify the risk of loss. To put it a different way, the reward has to be high enough to compensate for losing trades.

Another trade will come along that will have the right setup conditions. ...