Risk Vs Reward is a concept that many beginner traders think they understand, but in turn do not truly understand. Even professional traders often forget the underlying meaning of risk vs reward. When we bring up risk vs reward, we often only think of a 2:1, 3:1 or 7:1 scenario, or in a currency based example, risking $100(risk) to make $300 profit(reward) would be an example of a 3:1 Risk/Reward ratio.
There are a couple problems when discussing Risk/Reward with beginner traders as well as others, even in business or real estate. Number 1 Problem is..
Trading stocks that are not even worth trading just because you have a good Risk/Reward Ratio. I see this far too often. A beginner will often say something like “I took that trade because of the risk/reward. IT WAS A 6:1 Ratio!! ” The problem is not the ratio, in fact that ratio is beautiful. The problem is when traders decide to buy or sell a stock based on the risk/reward as the primary factor. There are a multitude of points traders should be looking at before getting into the trade that should be treated like a checklist. For example,
*Time of Day
There are more points to look at, but the point is that just because there is a good risk/reward ratio doesn’t mean that the stock is going to have a good chance of reaching that reward area. The focus should be on choosing a trade that shows the best probability of going in your favor, THEN you apply risk/reward.
Which would you rather?
#1) A stock that has a 2:1 Risk/Reward but has great news out and good amount of volume coming in
#2) A stock that has 7:1 Risk reward but has no catalyst and trades 100K volume which a huge spread
Obviously this example is exaggerated but lets hope you picked #1. Picking stocks with more likely hood of going in your direction will always help your trading career flourish more than picking and trading stocks strictly off risk vs reward.
The Number 2 Problem with beginners and Risk/Reward is
Truly being able to to RISK the money you say you are willing to lose. When we say “only put in money your willing to lose”, traders and others alike often agree to do so without really understanding the extend of what that phrase means. If you have a $1000 small trading account, and you’re risking $100 dollars to make 2x, 3x or 4x, it doesn’t matter what it is. What often happens is when you take that $100 dollar loss, it is a big loss relative to the account. As a result of this it often will make you hesitate or over think you’re next trade simply because fear of losing another 10% of your account. I’ve definitely been there before. So in this case you should lower the amount your willing to lose, which in turn will lower the amount you are willing to make.I know , I know, we all want those $300+,$500+,$1000+ winners, but you have to think first about how to preserve your account until you are in a position to take bigger hits. If you take 1 $400 dollar loss on a $2000 dollar account because you were trying to hit the lotto on that one trade, I can almost promise you wont feel like trading the rest of the day. Even if you do, the mindset of someone losing 25% in there account in one trade often calls for revenge trading afterwards. Bad idea. Bad,bad idea.