One of the basics investors need to know when making an investment decision is the risk/reward relationship of the trade. But just because it’s basic and necessary doesn’t mean you know how to calculate one. Today, I’ll show you.
I always look at the risk/reward relationship before entering a trade. It doesn’t matter whether it is a stock trade, an options trade, or a futures trade. The first thing I look at is the risk. And I always have a stop-loss point in mind to protect my investment.
Here is an example – a recent short-term stock trade I analyzed with my colleague Andrew Gordon…
The stock was trading at $86 at the time. A good stop-loss point would be a move below the 50-day moving average, which was at $84. If that happened, our loss would be in the vicinity of 2.5 percent. The chart showed clear resistance at the $96 level, so our target gain was $10 or 11.6 percent.
If we take the target gain of 11.6 percent and divide it by the target loss of 2.5 percent, it gives us a risk/reward ratio of 4.6. This is a very good risk/reward ratio.
I make trades only with a risk/reward ratio over 3.0, the higher the better. And when I combine this basic tool with the leverage provided by options (the type of trade I do most frequently), I can create extremely nice returns.[Ed. Note: Using basic tools like the risk/reward ratio can help you maximize your gains and minimize your losses. Despite what you may think, investing doesn’t have to be super-complicated. In fact, once you learn a simple trading secret from professional trader Rick Pendergraft, you may find that making money is easier than you ever imagined.]