How to calculate the risks of losing money when trading stocks with DotBig
Reducing risks is one of the most common issues stocks traders are concerned about. Obviously, no one wants to lose money. That’s why people try to calculate the risks, predict the threats, and take favorable decisions.
We face risks when trading stocks because of market volatility. Prices of shares are constantly showing changing tendencies, either declining or growing. Because of this, we cannot avoid the risks completely. Our task is to make their impact less harmful. Calculating is the first step to minimizing risks and increasing gains. But how is risk calculated? We are here to figure this out.
Introduction to the risks/reward ratio
Are you willing to take risks for the sake of potential gains? If not, you should learn how to calculate risk/reward ratio when trading stocks. This formula isn’t quite complicated for individual traders even if you are new to the stock market. To calculate this ratio, divide the reward by the price of your maximum risk.
The risks are mitigated when the risk/reward ratio is high. For example, if it is 2:1, most participants will dare because of the appealing benefits.
Knowing the risks of losing money is very important for those who aim to prevent them. This idea is simple: if you are aware of the risks, you will have a chance to reconsider the deal and manage them more efficiently. Let’s get deeper into this.
How to calculate risk
To understand how the above-mentioned formula works in real conditions, let’s take a look at the example. Imagine, you bought 10 shares worth $30 each. Previously, this stock was valued at $35, and you expect it to return to this price in a short period. Let’s imagine your expectations were satisfied. This means that your net profit will be $5×10=$50. Now, to find out the ratio, you divide this amount by the total amount you paid for the stocks: $50/$300=0.16. So the risk/reward ratio is 0.16/1. Most stock investors wouldn’t consider such an idea.
If you try to calculate the forex risk-to-reward ratio with the help of this formula, you will see that the majority of stocks are very risky to invest in. To mitigate the possibility of losses, you should take time to look for assets that suit your needs. It might be quite time-consuming but this is a necessary part of a productive analysis that will bring more gains.
Apply stop-loss and take-profit orders
Let’s consider the previous example again. Experienced investors don’t place $300 at risk with such a low ratio. Even if they agree upon such deals, they minimize the losses with the help of stop-loss features. This is a special order that allows to set that minimum prices and is executed automatically when the conditions are satisfied. You can set the lowest price at $25 and the position will be closed automatically if the quote reaches this point in order to prevent further losses.
When you set a stop-loss order in this deal at the point of $25, you risk only $125 ($5×$25) instead of $300. Now, your risk-to-reward ratio will be $50/$125=0.4:1. Although this is still not a profitable deal, this is much better than before. You can manipulate the stop-loss order and set the maximum downside of $1.5 per share, for example. In this case, you will risk only $45 and the ratio will become more profitable and less risky — 50/45=1.11:1.
DotBig does offer its clients to apply this type of order to make trading more profitable. You can register a demo account and sample how this tool can help in real trading conditions in the stock market. We believe that this option is much more beneficial than risking your cash without serious reasons and understanding how the market actually works.
One more good feature that can be handy for both beginning and experienced stock traders is called a take-profit order. This is also a type of limit order, but its main function is to bring profits not to prevent losses. When you set a take-profit order, you agree that your position will be closed automatically only when it reaches the profitable point. Stock traders apply this feature for their short-term trading strategies because it’s the most efficient way to take small but guarantees profits when day trading.
Both stop-loss and take-profit orders exclude all emotions, just mathematical calculations that minimize your losses to the possible extent. If you don’t use them, you might be hesitant about whether it’s a good idea to sell a position or take profits at a certain point. Your emotions might force you to believe that everything will change for the better. These mechanisms don’t consider such things — they are executed when it’s profitable for a trader, and that’s it.
The final thought
If you are a wise investor, you will use all available tools to prevent losses and maximize your profits. You shouldn’t take too serious a risk without applying instruments that can minimize your losses. Luckily, you have such a possibility with the DotBig forex broker. Learn how to calculate the risk/reward ratio and use different types of orders with us.