A friend of mine asked me recently how I determine if a trade offers a good Risk / Reward? What does that term mean?
To put it very simply, the amount of risk is the $ amount I would lose if the trade goes against me and the reward is the amount of money I make if the trade goes according to my plan. Defining those amounts are key to any risk management system. The Idea is that I abstain from trades that don’t make at least 3 times what I stand to lose.
Brackett orders are ideal for this kind of trading where there are two sell orders attached to the original entry. One is the stop loss and the other is the profit stop. I define the prices for the entry, stop loss and profit stop from the price action on a chart.
As an example, take a look at ACI, Arch coal inc. An entry, buy order placed at $28.44 with a stop loss at $27.98 with a target of $31.50. The Risk is 28.44 – 27.98 = 0.46 or 46 cents per share and the potential Reward is 31.50 – 28.44 = 3.06. That is 3.06 / 0.46 = 6.65 Reward / Risk ratio.
I built handy Risk management calculators in the Journal to quickly determine position sizes and prices. I also use the StockTradeCalc on my iPhone.
