Risk, in one form or another, is a part of our everyday lives. Cross the street mid-block and you will get to your destination quicker, but you run the risk of getting a jaywalking ticket or being hit by a car.
Unfortunately, in the stock market, risk is not always that clear-cut. However, a simple method for selecting your trades can help tilt the risk/reward odds in your favor and improve your chances for desired results.
It’s called the “R method”—the “R” referring to both risk and reward. The R method involves creating a ratio between the two Rs. If your brain is starting to swell a bit at this point, hang in there with me, it’s not as complicated as it sounds.
Many seasoned traders would say that before they put on a position, the first thing they do is determine where their stop will be—that is, the price point at which they would consider the trade a failure and bail out.
That stop becomes the risk component of your R method. It’s the difference between the price where you might enter the trade and the price where you might get stopped out. The more objective that stop point is, the better. Chart-based stops can be tied to price support and resistance levels, technical pattern breakdowns, or other technical indicators like moving averages.
Reward is determined in a similar way. Again, using objective criteria, identify your targeted gain—the point at which you’d likely take your profits. That’s considered the potential reward.
Once both Rs have been determined, the reward is divided by the risk to create a ratio. For example, suppose you decide to buy shares of XYZ if it breaks $100. You have determined, based upon a technical support level, that you’d place your stop at $99.50. The difference between those two prices is your risk, in this case $0.50, or 1R.
Now, let’s say your first reasonable profit target is a resistance level at $101.50, which is $1.50 above your entry point. This is equal to 3R, since $0.50 goes into $1.50 three times. So, you are risking 1R ($0.50) for a potential reward of 3R ($1.50), or 1R:3R.
Why is the R ratio so important? Because by choosing setups with favorable risk/reward ratios, you could withstand a higher percentage of losing trades and still realize an overall portfolio gain.
Anyone who takes 1R:1R setups would potentially need to profit on at least 50% of their positions just to break even. But applying setups with a minimum risk/reward ratio of 1R:3R means you’d only need to profit on about 30%.
By using the R method consistently and with the highest risk/reward setups, you stand better chances of being a more profitable—and more relaxed—trader over the long run.
To Hedge or Not to Hedge?
Learn trading strategies that help control your risks in an archived Trade Architect webcast led by TD Ameritrade's Cindy Faber.