How to Determine Risk/Reward Like the Pros

If somebody asked you to explain risk/reward, what would you say?

You’d probably say that it tells you if there’s enough upside profit potential to justify the risk. You’re right, but how do you know? Did you know that risk/reward is a calculation and professional traders would tell you that if you aren’t calculating your risk/reward, you’re likely entering into a lot of bad trades?

Before we look at the calculation, understand that risk/reward doesn’t forecast probability. From a pure risk/reward standpoint, playing the lottery is an outstanding investment but from a probability perspective, you’re better off picking any random stock and hoping for the best.

To determine probability, combine fundamental and technical analysis to find your upside price target. Then, apply the risk/reward calculation.

The Calculation

Let’s say you’ve exhaustively researched Deere and you feel that it’s an attractive trade. For the sake of simpler math, let’s say that Deere is currently at $80.

Your research led you to believe that it has upside potential of $105. You’re ready to purchase 100 shares for a total of $8,000. (Let’s not worry about commissions.) Given your price target, you have the potential to make $2,500 or 31 percent if Deere reaches $105.

To find the risk/reward, divide the net profit ($2,500) by your maximum risk ($8,000).

This gives you a risk/reward of 0.31:1. Investors aren’t interested until the risk/reward reaches a minimum of 2:1. That makes this a terrible trade, right?

Not so Fast!

Unless you’re an inexperienced trader or have money to burn, you’re not going to let the stock go to zero before exiting. When you put the trade on, you also placed your stop loss trade to limit your downside risk. How do you set your stop loss? This is where that risk reward calculation really shows its power.

If you want to reach at least 2:1 (the pros aim for 3:1 or 4:1), place your stop at $70. ($2,000/$1,000 = 2 or 2:1) You already decided on your upside target. Don’t change that number

For short term traders who are only looking for a small gain before exiting the trade, their stop has to be tight to meet the minimum risk/reward.

Maybe you like Abbott Labs (NYSE: ABT) as a short term trade. It’s currently at $36 and your price target is $37 for a 2.7 percent gain. If you purchase 100 shares, your maximum profit is $100. To achieve the minimum risk/reward of 2:1, set your stop at $35.50. ($50/$100 = 2 or 2:1)

Other Considerations

  • Don’t forget to add commissions, margin interest, and other fees into your price.
  • When you apply this formula to your trade ideas, you’ll be forced to abandon many of your ideas until the price becomes more favorable. Risking a lot to gain a little isn’t worth your time or money.
  • For longer term trades, changing fundamentals may adjust your price target. If the risk/reward becomes unattractive, exit the trade.
  • Because risk/reward can’t help predict probability, you won’t avoid every losing trade but it will help you limit your losses.
  • Don’t make emotional decisions. Adjusting your price target to achieve an attractive risk/reward puts your money in more danger. Be kind to your money. Don’t put it in harm’s way unless your potential for big profits is big.

(c) 2013 Benzinga.com. Benzinga does not provide investment advice. All rights reserved.

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