V.4:7 (254-255): Considering risk by James Covington Bryce

Considering risk by James Covington Bryce

Risk and reward appear to be a double-edged sword. Most professionals advocate that you calculate them both before entering a position. This is normally done in terms of a ratio where first you determine the difference between your entry price and your stop loss—this is your risk. Then you determine the difference between your entry point and your expected profit. This is your reward. A risk-to-reward ratio of 1-to-3 is normally considered the minimum you should accept and ratios of 1-to-5 or higher are even better.

Let's look at this idea a little more carefully. In calculating the risk part of the equation, we can be relatively certain that the calculation will be accurate—with the exception of being caught in a limit move if you trade commodities—assuming you allow enough for slippage. Allowing for slippage means allowing for fills that are slightly unfavorable.