Risk and Reward is a calculation made by investors when deciding whether a particular trade is mathematically sound to pursue - it is calculated by dividing your maximum reward (profit) by your maximum loss (risk).

In this guide, you'll learn:

- Why Risk and Reward is so important
- Understanding why max risk rules matter
- Risk and Reward in application

Unfortunately, if you've ever looked at the statistics for how many people actually make money in the market, it's pretty small. Generally, it's accepted that only about 5% to 10% of day traders actually succeed in the market. It's a rough statistic, but many newer investors struggle to apply risk and reward effectively while trading - and proceed to either: 1) blow up their account or; 2) lose money and then give up.

So, how does the risk/reward ratio keep you accountable to profitable trading? Critically, it allows traders to minimize their losses by cutting off losers early while maximizing winners by letting them run.

Even excellent day traders rarely have a win-rate of over 40-50%, so ensuring that your losses are minimal is critical for long term success!

Every trader must be willing to accept that not all trade ideas will work - frankly, for most traders... most ideas don't end up working. Any good trader makes effective use of hard stops to protect their account if an idea isn't working in their favor. 

Hard stop rules reinforce risk and reward criteria by forcing traders to accept controlled losses as opposed to holding on to "hope" that the trade will begin to work in their direction, taking emotion out of the equation and sticking to the technicals.

Max risk rules are especially important for small accounts looking to compound because, as a small account, you have little to zero margin for error in the trades made. Being able to have that set stop gives you the opportunity to live another day - and as long as proper risk and reward is being applied, you have a higher chance of succeeding and growing that small account.

Consider the following: A trader purchases 100 contracts of ABC Company for the $10 weekly call strike price based off an alert for a $1 premium at full size. The trader then also places a stop loss order at $0.75 per contract which will trigger a market sell order if the price of the $10 call strike loses 25% or more in value since the entry.

The trader believes that the price of the stock has room to the $13 upside resistance range after triggering an alert that signified a multi-month breakout on the upside. If the stock had the room to be three points in-the-money, the minimum expected price of that contract by expiration if it hit the $12 level would be $2 per contract.

The trader is risking a max loss of -$2,500 in order to potentially make $10,000 in profit or more on the upside. This particular trade has a 4:1 risk/reward relationship where the trader has a potential to make 4x the maximum risk associated with the position.

However, it's important to note the following:

Position entry, scaling, and sizing are critical to implementation of risk/reward, especially for weekly option trades. Using the same example above, the risk/reward criteria can be technically modified to assume a higher ratio by moving the price of the stop closer to the average of the entry point -- let's assume 10% lower than the entry point triggers a stop loss. In this case, the max risk associated with the position is lower, while maintaining the same upside potential; this does technically inflate the risk/reward ratio, but isn't ideal.

Why is that? Well, there's a much higher likelihood that the trader will be kicked out of their position since the stop is so close to their average entry. It's important to allow your position room to work by setting stops at mathematically sensible levels while also managing sizing and scaling of the position over time.

This isn't easy to accomplish, but once it makes sense and trading experience grows, it pays off big time!

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