The risk and reward ratio in trading
Suppose a trader buys 1 share of Company A at 20€.
The trader expects the price of the shares to rise to 30€ per share and sets a limit sell order at 30€. The trader then sets a stop loss sell order at 15€ in case the price of the stock falls unexpectedly.
In this trade, the trader risks a loss of 5€ for a potential gain of 10€. This would result in a risk/reward profile of 1:2 on this particular trade, as 5:10 can be reduced to 1:2.
Most traders have a standard risk/reward profile for their trades, which they use either as a fixed ratio for setting stop loss orders or as a rough rule of thumb when designing a trade.
The idea behind using a risk/reward profile to guide trade performance is that it provides a strong and consistent system for setting appropriate stop loss orders. Traders should risk only so much potential loss in relation to the potential gains from a trade, and this ratio should be consistent in most trading situations.
This means that the risk/reward profile also serves as a means of evaluating trades. Imagine a trader sees that he needs to set a specific stop-loss level for a particular trade, but is concerned that the price could easily trigger that stop-loss before it even rises to reach its price target.
This fear that the prescribed stop loss level will be triggered is a strong signal that this is a bad trade that should not be executed at all in its current state.
Different traders will use different risk/reward profiles depending on their trading strategies, but most risk/reward profiles will be between 1:2 and 1:5. Anything below this range is considered extremely risky and anything above is considered very conservative.
Whether the trader uses their risk/reward profile as a fixed rule or as a rough guideline also depends on the individual day trader.
In general, it is considered a good idea for new traders to use a fixed risk/reward profile to provide additional structure to their trade, while more experienced and seasoned day traders often feel comfortable using their risk/reward profile as a simple guideline for the basic structure of their trade.
Even traders who have never heard the exact term "risk/reward profile" will find that they have used a rough example of the concept as a guide for structuring their trades.
It makes sense for an individual trader and their trading strategies in Singapore Exness to demonstrate consistency in structuring their trades based on their personal risk tolerance and the exact details of how their trades will perform.
While it is strongly recommended that new traders use a fixed risk/reward profile at the start of trading, more experienced traders find that their risk/reward profile becomes more of a rough guide over time.