How I Calculate My Reward-to-Risk Ratio

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Stock Market Investment and Trade Strategies - JayceeDeGuzman.com

Initially, my goal for the Stock Signals Philippines is to only accommodate busy employees and entrepreneurs. It was originally designed for long-term position investors. But because I have clients who want to trade on their free time with their free cash, I’ve started to welcome traders, too. The Private Clients Forum is an avenue for traders to request my stock analysis.

So, in this article, I’d like to share with you how I calculate my reward-to-risk ratio.

First, I identify the support and resistance price points of the stock. I do it either by plotting the support and resistance points by using the classical definition of support and resistance, by using Fibonacci, or other technical indicators.

If you are my client and you don’t know how to plot support and resistance lines manually, just open the solo page of that stock from our Automated Stock Ranking System and you’ll find the real-time three levels of support and resistance for that stock.

Why is it important to define your reward-to-risk ratio BEFORE entering a position to any stock you’d like to trade? These are the three reasons that are at the top of my head.

These are the three reasons that are at the top of my head.

  • so you can visualize how much you’re risking over how much you’re planning to win;
  • so you will plot your support and resistance points FIRST instead of relying on pure instinct for your desired entry, stop-loss, and selling points; and
  • so you can plot your stop-loss point based on your percentage of risk tolerance.

A few months ago, I wrote: “How to set your reward-to-risk ratio (and why you have to)“. Please read it before you continue reading the remainder of this article.

If you’ve already read that other article, by now, you must have a clearer idea about the importance of identifying your reward-to-risk ratio. By the way, others prefer to call it risk-to-reward ratio. That’s fine. Call it however you like it.

I’d like to use FNI for demonstration purposes. Note that I am not, in any way or degree, indirectly implying a recommendation to trade FNI based on the values I plotted in this calculator. I already said it but I’ll say it again that this is for demonstration purposes only.

So, let’s say Peter is my client. He wants to do a quick play on FNI. He plotted the Fibonacci retracements.

Stock Signals' Reward to Risk Ratio Calculator - FNI

Right now, Peter has a spare of P50,000.00 to trade in his free time.

He can afford to buy 100,000 shares of FNI.

His risk tolerance when trading (short- to medium-term) is up to 7% only.

He chose 0.49 as his entry price.

He inputted P0.46 as his stop-loss price because that’s still within his risk tolerance of 7%.

Assuming he uses my reward-to-risk ratio calculator, know that it auto-computes the values not highlighted in orange.

If Peter inputted 0.45 as his stop-loss price, he would have gotten a potential risk of 8.16%.

But he didn’t like that because that’s outside his risk tolerance of 7% so he marked his stop-loss price back to 0.46.

Stock Signals' Reward to Risk Ratio Calculator 1

Peter chose the 50% of Fibo retracement as his selling price, which is 0.57. For him, that is more realistic.

So, he plotted 0.57 in the Target Price cell.

Then, his potential gain shows 16.33%.

With his entry price of 0.49, the stop-loss price of 0.46, and target price of 0.57, his reward-to-risk ratio is 2.67.

To Peter, a ratio of 2.50-and-above is fine so he took 2.67 as an acceptable or tradable ratio.

With that ratio, Peter is at risk of losing P3,000.00 with a chance of winning P8,000.00.

By calculating my reward-to-risk ratio, it is now necessary for me to check the chart before I trade. I should check whether my target selling price is more realistic and achievable. I know that the price chart is a representation of the “emotions” of traders.

It’s now for me to decide whether I’ll use my buying power at once or buy in tranches depending on the volatility or liquidity of the stock.

How about you?

Do you calculate your reward-to-risk ratio BEFORE you enter a new position?

What have you learned from me in this article? Let me know in the comments below.

Jaycee De Guzman

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