How to Calculate the Risk/Reward Relationship of a Trade

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.]

Inspired by his high school economics teacher, Rick Pendergraft fell in love with the markets at an early age. He entered his first investing competition at 17, and opened his first brokerage account before he finished college. At the age of 23, on the third options trade he had ever placed, Rick turned $1,800 into $22,000 in less than a week, when the company he bought became the target of a takeover. He admits it was a stroke of luck, but it was a memorable education as to the leverage that options can provide. After a ten year career in banking, Rick decided to pursue trading full-time. To get his foot in the door, he started out in the sales department at Schaeffer's Investment Research. It was not long before his talent was recognized and he was invited to apprentice under Bernie Schaeffer, one of the top options traders in the world. Rick thrived in his new position and twice received the award for "Top Trader."Rick has developed a loyal following of readers who are grateful for his timely warnings and profitable advice. He is widely recognized as a market expert and has been frequently quoted by Reuters, BusinessWeek, Forbes, USA Today, the New York Times, and the Washington Post. Rick's primary focus is on identifying short and intermediate term rising and falling trends in the major market sectors. His analysis is based on technical factors along with indicators of market sentimentRick lives near Delray Beach, FL with his wife and three children.