Money management is what makes a real difference to your funds. In both everyday life and trading, it is about deciding how to spend your money and how to smooth out any negative outcomes of this spending.
In trading, you are exposed to risk all the time, especially when you trade on margin. Leverage is a magic magnifier of potential earnings, however, it can wipe out your account in a blink of an eye. You can afford bigger trades and rip greater profits, but lose a lot in the meantime.
Sound money management includes stop losses and a risk to reward approach. Stop losses, if set efficiently, can help limit capital losses. The risk to reward ratio (RRR), in turn, shows how much you are ready to lose (risk) on a trade relative to the profit (reward) you expect on this trade. Many traders neglect introducing this metric to their strategy and end up with heavy losses.
The calculation of risk to reward ratio on a single trade is not complicated. Risk is determined using a stop loss level, or the difference between the entry and the exit price should the trade move against you. Reward establishes the difference between the entry and expected exit points in case of favourable price movements.
For example, you go long on one stock priced at €50.40 and set a stop loss at €50.20. Thus, the risk per trade is €50.40 – €50.20 = €0.20. According to your estimates, the stock price will rise to reach €50.80, so you choose this point to be your reward target. The potential profit is €50.80 – €50.40 = €0.40.
Now that we have both the risk and reward, we can calculate the risk to reward ratio per trade: €0.20 / €0.40 = 0.50 (or 1:2). The ratio is less than 1.0, so your potential profit is bigger than risk. If your ratio is more than 1.0, then your risk per trade is greater than reward.
So, what’s the preferred RRR?
It is commonly believed that the best ratio is 1:3 or 1:2. The 1:1 and any other risk reward ratio where risk outweighs reward is not recommended.
However, decreasing the risk to reward ratio by placing tighter stop loss and wider take profit orders does not guarantee better trading performance. Unfortunately, it’s not as simple as that. Reasonable money management implies choosing the right position size and suitable risk per trade, as well as considering volatility when placing stop losses.
After you’ve chosen a market to trade, you have to define a preferable risk per trade level. This is a certain percentage of capital that you can withstand losing on a single trade. 2% is the most common risk per trade. Traders, however, can choose a bigger and a smaller percentage, depending on their risk tolerance.
Bear in mind that you can lose several trades in a row. In such an adverse situation, 2% per one trade turns into 10% of your capital, which evaporates should you lose 5 consecutive trades.