On Risk and Reward in Stock Trading

A note on the matter of risk/reward analysis: Lets say you are trend trading the S&P 500. You’ve charted resistance around 1040 and support at 950, and we’re at 1027 now. If you’re long, you are implicitly risking a 77 point downside to capture a 13 point upside. That’s an unfavorable tradeoff, and in this situation you shouldn’t want to go long, but may consider going short.

Now, let’s say the SPX is at 980. Here you’re risking 30 down to get 60 up in a long trade. That’s a higher probability outcome, so you might enter at that point, though waiting to get to that support line might be better still. Even then, there’s no guarantee that the market will go the way you anticipate, so you maintain a sell discipline if the trade goes against you.

This sort of risk/reward analysis should always be made when considering a trade. In essence it enforces the old “buy low and sell high” axiom, and applies to all trading markets, not only stocks. It’s a practice that tilts the probability of a positive outcome in your favor.

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