Stock Market for Beginners

In my position sizing article, I talked about the importance of setting a stop loss target every time you make a trade in order to manage your risk. In this article, I will talk about the importance of envisioning a stop profit target in order to determine your risk/reward ratio. Understanding this ratio is crucial to a solid trading strategy.

In order to calculate the risk/reward ratio for any trade you make, you’ll need three numbers:

1. Entry price
2. Stop loss target price
3. Stop profit target price

The entry price is the price at which you plan on purchasing the stock at. The stop loss target price is the predetermined price at which you will sell your stock for a loss if it falls to that price. The stop profit target price is the predetermined price at which you will sell your stock for a profit if it rises to that price.

For example, if you were to buy Intel (INTC) at $25, that’s your entry price. Let’s say that I don’t want to take more than a 10% loss on my investment, so my stop loss target price is $22.50. In addition, I believe that Intel has the potential to reach $30 – this is my stop profit target price. Determining these stop prices effectively is one of the most difficult things to do in investing. In the next article, I will discuss different methods of determining your stop prices.

Your risk is the amount of loss you are willing to take per share of the stock:

Risk = Entry price – Stop loss target price

Your reward is the amount of profit you want to take per share of the stock:

Reward = Stop profit target price – Entry price

Obviously, then:

Risk/Reward Ratio = Risk / Reward

Let’s go back to our Intel example. Your risk for the Intel trade is $25 - $22.50 = $2.50. Your reward for the Intel trade is $30 - $25 = $5. Therefore, your risk/reward ratio on this trade is 1:2. That is, for every $1 you risk on this trade, you have the potential to gain $2.

Clearly, it makes sense then to pick the trades that give you the most reward for every $1 you risk. Most traders will recommend a risk/reward ratio of at least 1:2 or 1:3. I will later discuss how you can manage your portfolio using risk/reward ratios to predict your expected rate of return based on your current performance.

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