Lesson T2.2 · 2 of 5 · Risk before every trade
Stop-loss and risk/reward ratio: where to set it and how to calculate
A stop-loss goes where the idea behind the trade stops being valid, usually just below the latest low. The risk/reward ratio compares what you risk with what you could gain. At 1:2 you make twice what you risk, so before costs you break even if you are right in just over a third of trades.
Terms in this lesson
- Stop-loss
- An order that sells automatically if the price falls to a level you choose.
- Support and resistance
- Prices at which a stock has often stopped falling or stopped rising.
- Trailing stop
- A stop-loss that rises with the price on its own and never moves down.
Where to place a stop-loss
Definition
Where does a stop-loss go?
Where the idea behind the trade no longer holds.
If you bought because the price bounced off a low, the idea fails when the price drops below that low. The stop-loss sits a little below it, so a mere touch of the level does not trigger it. You then work out the position size from the distance to the stop, as in the lesson on the 1-2% rule.
- A stop set by how much it hurtsThe market does not know how much money you have. Where the stop goes comes from the chart; the amount at risk comes from position size.
- A stop too closeOrdinary daily swings knock you out of trades that would have worked.
- A stop moved lower out of hopeYour risk grows at exactly the moment the chart says the idea was wrong.
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Create a free accountHow to choose a profit target
Example
Where does the target go?
At a level where the price stalled before, or at a multiple of your risk.
The first obstacle here is the previous high, 50.22: that is where others sold last time. The 52.80 target sits above it and pays twice the risk. Some traders sell part of the position at the previous high and let the rest run with a trailing stop.
The same chart with four levels: the stop at 46.50, below the pullback low; the entry at 48.60; the previous high at 50.22; the target at 52.80, twice the risk.
1:2 and 1:3 risk/reward: how often you need to be right
| Ratio | A win pays | Minimum win rate to break even |
|---|---|---|
| 1:1 | what you risked | 50% |
| 1:2 | twice the risk | 33.3% |
| 1:3 | three times the risk | 25% |
Before costs. The break-even rate is 1 ÷ (1 + the reward as a multiple of the risk). Commissions and spreads push it higher.
Lessons are educational. They are not a recommendation to buy or sell. Investing involves risk and you can lose money. Sources: the lesson’s own calculations. The charts are teaching diagrams, not real prices.