When many people think about risk, they tend to think in terms of the percent chance that a given trade will be successful. That’s not the type of risk we’re talking about here. In this case, we’re specifically talking about the maximum probable dollar loss that a given trade can result in.
If your goal is to achieve stable, reliable long-term profitability (and it should be!), two key questions you need to ask yourself about every trading opportunity you consider, are:
1) Is the amount you’re risking within acceptable bounds?
2) And, is the reward sufficient to warrant running the risk?
While the first question is typically fairly easy and straightforward to answer, the second one is quite complex. Unfortunately, many novice investors don’t do their answers justice, tending to keep things very simple.
Here’s an example of what a “typical” novice answer to question 2 might look like: “my reward needs to be at least twice the amount I’m risking.”
There are a couple of major problems with this approach. First, it doesn’t take into account the probability of actually hitting that mark, and second (and every bit as big a failing) is the fact that it doesn’t consider the availability of trades that meet that lofty criteria. In short, a system based on a rule like that is almost destined not to be very profitable, if at all.
A better approach would be to determine an appropriate reward:risk ratio for your trading system, then observe how changes to the ratio for a series of trades impact the “expectancy” of each series.
Expectancy is a measure of how effectively a trading system utilizes risk. You can calculate it by dividing the total profits and losses by the total number of dollars risked for a given number of trades.
An expectancy of +20c, for instance, means that in the long run, the trading system in question would produce 20c of profit for every dollar put at risk.
This, and other techniques used to determine an appropriate reward:risk ratio should be used with caution, and the understanding that the results are only as accurate as the test trades are representative of the market and the system being tested, and for a comparable frame of time.
Note: TradingLounge has calculators to handle CFD Trade calculations within its CFD Portfolio software. It also has advanced contract strategies for Forex and Indices trading, a financial plan to trade by.