Risk versus reward
Risk is the amount you are willing to lose if the trade reaches your planned stop-loss. Reward is the potential profit if the market reaches your target.
A trade with a potential reward of $200 and a potential risk of $100 has a risk-to-reward relationship of 1:2.
Evaluating a trade before entry
A trader should identify the entry price, stop-loss level, and profit target before opening a position. These levels help estimate whether the setup offers a reasonable opportunity.
- Where will the trade be entered?
- Where is the trade invalidated?
- How much money could be lost?
- Where is the profit target?
- Does the potential reward justify the risk?
Trade expectancy
A trading strategy can be profitable even if it does not win every trade. What matters is the relationship between win rate, average win, and average loss over a large sample of trades.
For example, a strategy that wins 40% of trades may still be profitable if its average winning trade is significantly larger than its average losing trade.