Once you've identified a trade you want to make and chosen a profit target, it's reasonable to ask how much you're willing to risk to earn the expected profit. The following steps explain how to calculate your risk/reward ratio.
Determining Your Risk/Reward Ratio
In the below example, we use the technical analysis concept of support and resistance to identify a target open price, profit exit and stop-loss exit. The sample stock's current price of $30 is near the lower end of the current trading range. We are comfortable opening the trade at this price. Since $30 is near recent support, the price could decrease and "break support," which would be a bearish sign. To limit a loss, we establish a sell stop at $29, which is $1 less than the $30 entry price. This $1 is the amount we're willing to risk on the trade.
To calculate the potential reward, we now look at recent resistance (i.e., the point where selling pressure increases, which causes the price to stall or decrease). While the stock price could rise beyond $33, history tells us that when it gets to this point, it decreases. That may mean that we are willing to close our position and take a profit if the price rises to $33. The difference between the opening price of $30 and our profit target of $33 is $3. This is the reward component of the risk/reward ratio.
The risk/reward ratio is simply the dollar amount that you are willing to lose per share compared to the profit that you are planning to earn. In our example, the risk/reward ratio is 1 to 3.
Keep in mind that you don't have to exit when the stock reaches $33 if you do ongoing analysis that suggests the stock may rally beyond the $33 target price. You may instead choose to adjust the whole position up, moving your stop-loss up to $32 and your profit target to $35. That maintains a positive risk/reward ratio and provides room for the stock to continue moving up.
Risk/Reward Ratio Ranges
Some traders believe that high-reward trades offer at least a 1:3 risk/reward ratio. Simply stated, you are risking $1 to gain $3. Moderate-reward trades offer approximately a 1:2 ratio. Low-reward trades have at most a 1:1 risk/reward ratio, meaning that the expected gain is the same or less than the amount of the potential loss.
The ratio you select will depend on your objectives and trading strategy.
Risk/Reward Ratio Considerations
When determining the appropriate risk/reward ratio, consider how the trade will behave. Traders with stop-loss orders near the opening price are more likely to get "stopped out." But choosing stop-loss values that are farther from the opening price results in a higher risk/reward ratio.
Using technical analysis or another method that you find works for your trading style, map out the support and resistance for a stock you're considering and calculate the risk/reward ratio of the trade. Once you've determined whether the opportunity offers a high, moderate or low ratio, you'll be in a better position to decide whether it's the right amount of risk for you.
Schwab does not recommend the use of technical analysis as a sole means of investment research.
The information here is for general informational purposes only and should not be considered an individualized recommendation or endorsement of any particular security, chart pattern, or investment strategy.
Past performance is no guarantee of future results.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.