Risk Reward Ratio

Risk Reward Ratio  In an earlier post, I talked about position sizing. Basically, if you don't want to lose your shirt in the stock market, you have to buy "smartly" - never placing a good portion of your money on a rather risky stock.  That tells you how much to buy. But how do you know if that stock was worth pursuing in the first place? That's where the risk/reward ratio comes in.  If you're going to make a risky investment, you might as well take the one with the highest payoff, right?
In an earlier post, I talked about position sizing. Basically, if you don't want to lose your shirt in the stock market, you have to buy "smartly" - never placing a good portion of your money on a rather risky stock.

That tells you how much of a stock to buy. But how do you know if that stock was worth pursuing in the first place? That's where the risk/reward ratio comes in.

To be clear, there are other ways to determine the "worthiness" of a stock - most importantly: fundamental analysis. But assuming that the fundamentals are ok...

The risk/reward ratio is basically what it sounds like - how much potential reward (gains, earnings) there is in relation to the risk (loss).

If you're going to make a risky investment, you might as well take the one with the highest payoff, right?

So how do you compute for it? Just divide your net profit (the reward) by the price of your maximum risk.

For example's (and simplicity's) sake, let's assume your favorite fast food stock is currently trading at Php100 (and you can buy just one stock; you know, to keep things simple).

Using technical analysis, you determine that support is at 95 and resistance is at 105. So the potential loss is 5, and the potential gain is also 5.

In this case the risk/reward ratio is 1:1. Not bad.

But let's say you waited a week and it went down to 95. Should you buy?

There's a chance it could fall further to 90 (the other, previous support). But 105 is still a good possibility. In this case the risk is Php5, and the gain is Php10.

In this case the risk/reward ratio is 2:1. That's a much better position, since you'll potentially get twice as much as you're risking.

However, risk/reward doesn't deal with probability. It just tells you that the potential gain is much more, but doesn't know and can't tell you which is outcome is likelier to happen.


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photo credit: wiredforlego via photopin cc

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