Page 399 - THE MARKET WHISPERER

THE MARKET WHISPERER 39 5

Risk Reward Ratio

Before trade opens, you have scanned the stocks in your follow-up list
and chosen those that interest you as trades. Some are marked “to buy,”
but your buying power is limited, and by nature you will want to lessen
financial risks as much as possible. How will you choose what to buy?
Among the various parameters that must be checked is the Risk Reward
ratio.

It is known simply as the RR.
• Risk refers to the sum of money you are willing to lose in a trade from

the entry point to the predetermined stop point.
• Reward relates to the sum of money you wish to gain from the trade,

from the entry point to the predetermined exit point.

In reality we calculate the risk to reward ratio in points. A typical
sentence may sound like: “It looks to me like the stop is half a point and the
target is one point.” In other words, I am taking the risk that the price will
move against me by half a dollar, in the hope that I will profit by one dollar.

If you ask professional traders, they will usually say that they expect an
ideal RR of 1:3, but in practical terms, they are willing to accept a 1:2 ratio,
and sometimes, even lower than that. What they mean is that during the
process of choosing a stock, they will be looking for one that may jump by
$3, but has a planned exit point (their stop) of only $1.

To determine the RR, traders will analyze the stock’s daily chart and its
intraday chart, watching for the closest support and resistance points and
the intraday volatility.

Why would we look for a 1:3 or even a 1:2 RR? What is wrong with
1:1? Our goal, of course, is to earn money with as little risk as possible. Let
us say you are experiencing a bad luck streak in a tough market, and you
successfully beat the market in only half your trades. If you profit in only
half the trades you execute, and are additionally paying commissions, you
will be doomed. By contrast, if you succeed to maintain a 1:2 ratio, so that
for every trade where you lose $1 you earn $2 in another trade, you will
maintain a positive balance. In this way, even if you choose the right stocks
in only half the instances, your status remains stable. Obviously, choosing