How to Determine Reward Before You Determine Risk
Most new traders understand the stop-loss.
One thing very few consider as it applies to money management is the probability of the trade. In other words, is it an outstanding idea or simply a good one?
Let’s use real estate as an analogy. If you know a neighborhood well, and you believe it is a nice one, finding an undervalued property in that area would warrant the risk. If the owner of the property or the bank required a bigger down payment you would be okay doing it because of the quality of the opportunity.
If house number two in the same neighborhood needed a lot of work but would not return the same profit as house number one you would probably think twice about making the investment. Many beginner traders tend to assess the entry levels without putting the quality of the idea in context.
In trader terminology this means what are the odds of my stop-loss being hit versus my profit target being hit? The better the odds of follow-through, the more you can justify risking on the trade. There is no such thing as a guaranteed trade, however, some trades absolutely have a higher probability of working out than others.
It’s your job managing your money to learn how to recognize the difference.
It’s important for beginner traders to understand this because when more money is available to be earned it’s imperative you have the proper risk in relation to the potential reward.
One thing very few consider as it applies to money management is the probability of the trade. In other words, is it an outstanding idea or simply a good one?
Let’s use real estate as an analogy. If you know a neighborhood well, and you believe it is a nice one, finding an undervalued property in that area would warrant the risk. If the owner of the property or the bank required a bigger down payment you would be okay doing it because of the quality of the opportunity.
If house number two in the same neighborhood needed a lot of work but would not return the same profit as house number one you would probably think twice about making the investment. Many beginner traders tend to assess the entry levels without putting the quality of the idea in context.
In trader terminology this means what are the odds of my stop-loss being hit versus my profit target being hit? The better the odds of follow-through, the more you can justify risking on the trade. There is no such thing as a guaranteed trade, however, some trades absolutely have a higher probability of working out than others.
It’s your job managing your money to learn how to recognize the difference.
It’s important for beginner traders to understand this because when more money is available to be earned it’s imperative you have the proper risk in relation to the potential reward.
How to Determine When Potential Reward is Greater
In my opinion the best method of determining the potential earning power of a trade is using top-down analysis. This means we will work our way down from the general market, to industries, to individual stock setups. The more of these factors you have in sync the greater the odds for a profitable trade.
The first thing you want to read is whether or not the general market is trending higher, lower or not trending at all. If it is that means more money is flowing into the market at the same time with the same opinions. This is the foundation of a high probability trade.
From there we narrowed down our scanning to industries traded alongside our market analysis. In other words if we have determined the market is trending higher our first choice would be to look for industries doing the same.
From those industries we would scan for individual stocks with patterns similar to the general market and the majority of industries mimicking the market. This type of analysis is called relative strength analysis, if followed with discipline this type of trading research will have high probability trades in your daily game plan.
Although much of money management comes down to the amount of risk capital in your account and also the amount of risk your comfortable taking, you should strive to learn when better opportunities are available so you are prepared to take advantage of them.
The first thing you want to read is whether or not the general market is trending higher, lower or not trending at all. If it is that means more money is flowing into the market at the same time with the same opinions. This is the foundation of a high probability trade.
From there we narrowed down our scanning to industries traded alongside our market analysis. In other words if we have determined the market is trending higher our first choice would be to look for industries doing the same.
From those industries we would scan for individual stocks with patterns similar to the general market and the majority of industries mimicking the market. This type of analysis is called relative strength analysis, if followed with discipline this type of trading research will have high probability trades in your daily game plan.
Although much of money management comes down to the amount of risk capital in your account and also the amount of risk your comfortable taking, you should strive to learn when better opportunities are available so you are prepared to take advantage of them.
