Assessing a Trades PotentialWhen looking at a stock to buy, we look to various tools and techniques to help us assess the probability of its upward movement. However, will it go up is not the only question to ask - we also need to analyze the chart to see how far it is likely to go up and also how much of a loss we are willing to take to allow it to reach it's profit potential. The potential profit of a trade divided by the potential loss of trade is known as the Reward:Risk Ratio. Our first chart of PCG shows the stock near a trend line on an upward trending channel. We will set our entry price at 21.4. How far will this trade move to the upside? The channel tells us that it should move to the upper channel line, so we can set our target at 23.50. We have our reward measurement of 2.1. Now we need to calculate risk. How far of a drawdown will we allow before we exit this trade? An even better question is "At what point is our reason for entering this trade no longer valid?" Since we are entering the trade based on the reversal off the lower trend line, we can use this to set our initial stop. If price reverses after hitting our entry price, we would say that 20.75 would be a sufficient move to break the trend line, and that stop gives us a risk of .65. Our potential reward is 2.1 and our potential loss is .65. So, our Reward:Risk ratio is 3.23. Any Reward:Risk ratio of 3 or above is considered very good, and we are looking at a good candidate based on this calculation. Reward:Risk Ratio: PP/PL (PP=Potential Profit and PL=Potential Loss) The most common mistake made when assessing
the Reward:Risk Ratio is setting the target price where we hope
the security goes, not where we can realistically expect it to
go. It is imperative when calculating Reward:Risk that we are
realistic about our levels. Dreamers beware, because cheating on
this calculation is of no benefit. |
PCG begins to turn against lower channel level
Reward Realized! PCG behaved well in its channel
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