One of the basics of the investing arena is to understand the risk/reward equation of a trade. It is crucial that every investor know this equation before making investment decisions; nevertheless, you, as an investor, may not know how to estimate one.
Here you will learn how to do it.
Before entering a trade -no matter if it is a stock trade, an options trade or a futures trade- an investor must look at its risk/reward equation.
First, he should look at the risk factor and always have a stop-loss point in mind to protect his investment.
Lets see an example of a short-term stock trade:
You are interested in a stock that is being traded at $86.
A good stop-loss point would be a move below the 50-day moving average; this is, at $84. In this case, your loss would be close to 2.5%. The chart shows patent resistance at the $96 level; so, your target gain is $10 or 11.6%.
Now, if you take the target gain of 11.6% and divide it by the target loss of 2.5% you get a risk-reward proportion of 4.6, which is a very good risk-reward equation.
We know a very good investor who only makes trades when the risk/reward equation is over 3.0, and the higher the better. When he blends this basic tool with the power provided by options, which is his preferred type of trade, he gets really nice profits.
Even though you hear different every day, investing does not have to be a pain in the b... Use basic tools such as the risk/reward equation and you will make the most of your gains and decrease your losses, and you will discover that making money is easier than you ever imagined!
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