Maintain risk reward ratio for steady profits

Money management is an important financial discipline to be maintained by one and all. Based on the income, one needs to budget expenditure and savings. Maintaining a saving fund helps meet some unforeseen expenditures like medical emergencies.

Suppose you are planning for children's higher education, or a vacation trip or some unforeseen contingencies like some health issues we need to save a part of an income mandatorily. Likewise, even in stock market money management plays a key role.

Let us see how to manage money in trading and investment. Whenever a trade has taken place, chances of winning the trade is only a probability but it is not guaranteed.

On an average we can say that whenever we take a trade the probability of profit is 70 per cent and loss is around 30 per cent.

A gambler would invest his entire capital into few trades and has every chance of winning a jackpot and also losing his entire capital. On the other hand, a professional trader will calculate his risk and then take a trade.

A professional trader's act of setting up a stop loss is risk management. He will not take more than a risk of two per cent in a trade. Let us try to understand money management with an example.

Suppose a trader has a capital of Rs 1 lakh, it is advisable to trade only 25 per cent of the capital. He should limit his risk to two per cent which amounts to Rs 500.

Most of the trading platforms give leverage but it is advisable to strictly trade only with the available capital.

In the above example if one maintains two per cent risk strictly then we may lose capital in 50 consecutive negative trades which is most unlikely to happen.

Instead of having jackpot trades it is better to have a consistent small profit yielding trades. Over greed signals the loss of the capital which one is likely to lose.

Let us see how to calculate risk. For example, if you buy a stock of price Rs 300 and we maintain a stop loss at 398 then the risk is around Rs 2.

This Rs 2 should be multiplied with the number of shares then the risk amount would be Rs 200.

The formula for calculating the risk is entry price minus stop loss price to be multiplied by number of shares.

The general acceptable risk reward ratio is anywhere between 1:2 or 1:3. Suppose we buy a stock which costs Rs 100 and if the stop loss is placed at 98 and if the price increases to Rs 104 the risk reward ratio is 1:2. With the risk of Rs 2 there is a possibility of winning Rs 4.

By strictly following risk reward ratio we will be able to make a consistent profit and simultaneously protecting our capital also which serves as the key instrument for trading.

(The author is a homemaker who dabbles in stock market investments in free time)