Before entering any trade, you should ask yourself a critical question: Is this trade worth the risk? 🧐 The answer lies in understanding and applying the risk-to-reward ratio.
What is this ratio? 🤔
Simply put, it is a comparison between the potential loss you might incur in the trade versus the potential profit you hope to achieve.
How do you calculate it? ➗
* Risk (Potential Loss): This is the difference between your entry price and your Stop Loss (SL) price. This is the maximum amount you are willing to lose.
* Reward (Potential Profit): This is the difference between your entry price and the Target Price (TP) you set.
* Ratio: Divide the risk by the reward.
Simple example: If you decide that you are willing to risk $100 to achieve a potential profit of $300, the ratio here is 1:3. This means you are risking one dollar for every three dollars of potential profit.
Why is it extremely important? 💡
* Logical Decisions: Helps you trade based on rational analysis, away from emotions, and avoid unprofitable trades.
* Capital Protection: Ensures that you do not expose your capital to excessive risk.
* Sustainable Profits: Trades with a good ratio increase the likelihood that your portfolio will be profitable in the long run, even if not all your trades are successful.
Golden tip: As a general rule, always try to look for trades where the risk-to-reward ratio is at least 1:2 (i.e., risking one dollar to gain two dollars). The better the ratio (like 1:3 or 1:4), the more attractive the trade! 💪