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2001issue C081

Construct reward to risk before entry

A position is withheld until an invalidating price and a confirming price are identified, converted into accepted loss and expected gain, and assembled into a reward-to-risk ratio so the loss bound exists before entry.

  • A position should not be opened until an invalidating price has been identified, because that price would show the entry assumption is wrong and it sets the loss bound.
  • A confirming price should also be identified before entry, because that outcome would show the entry assumption is right and it sets the expected gain.
  • Accepted loss and expected gain come from those prices, and the reward-to-risk ratio is formed by dividing expected gain by accepted loss before a position is opened.
  • In this construction, the everyday label risk is treated as a misnomer for the accepted-loss amount.
Entries in this reading1 entry
Current trackRisk-reward ratio78 readings

Identify both prices first

A position should not be opened until a price that would disprove the entry assumption has been identified. That invalidating price is the price that would show the entry assumption is wrong, and it therefore sets the loss bound.

A price outcome that would confirm the entry assumption should also be identified before entry. That confirming price is the price outcome that would show the entry assumption is right, and it therefore sets the expected gain.

Convert the prices into the ratio

The invalidating price is converted into the loss one is willing to accept. That accepted loss is the quantity used as the ratio denominator.

The confirming price is converted into the gain one expects. That expected gain is the quantity used as the ratio numerator.

The reward-to-risk ratio is formed by dividing expected gain by accepted loss. In this construction the figure is assembled before a position is opened.

What the word risk stands for here

In this construction, the everyday label risk is treated as a misnomer for that accepted-loss amount.

Educational research material, not investment advice. Historical source context does not establish present-day performance.
5 of 27 in the Risk-reward ratio track
20031-2 pp.Next on Risk-reward ratioA pre-trade readiness checklist for entry, abstention, and riskIll-equipped participants are described as missing at least one of confidence, funds, a plan, and understanding, a readiness gap that turns early errors into a learning-curve cost rather than a surprise.
All readings on this track · 27 readings
  1. 1987Precommit the stop and require a surplus payoff
  2. 1987When open losses overwrite precommitted exit rules
  3. 1991Ranking month-end holds with risk-reward and stops
  4. 1994Evaluating percentage profit exits on trend-following averages
  5. 2001Construct reward to risk before entry
  6. 2003A pre-trade readiness checklist for entry, abstention, and risk
  7. 2003Evaluating out-of-the-money strikes with saddle premiums and implied volatility
  8. 2004A critique of one-procedure trading decisions
  9. 2004Mechanical stops leak intent and misprice losses
  10. 2004Implied-volatility premium on rate indexes
  11. 2006Keep the stop that authorized the entry
  12. 2006Bound the loss with a risk-to-reward filter before entry
  13. 2007Audit the operator before abandoning a system
  14. 2007Failed-break slingshot reversal rules
  15. 2007A system-management template that sets the stop and the required reward before entry
  16. 2007Construct a pre-trade style envelope for entries and skips
  17. 2008Systems that skip the three decision gates
  18. 2010Four-gate veto before trend entries
  19. 2012Construct a trading plan as one written procedure
  20. 2012Forex stops and reward targets by quote increment
  21. 2013The average directional index as a lookback cluster and a risk-reward bound
  22. 2014A three-step worksheet for VIX futures tick value and low-vol risk-reward
  23. 2014Binary option premia, fees, and pre-expiry risk-reward
  24. 2015Selling far out-of-the-money commodity option premium as a forgiving timing case
  25. 2016Prepaid option spreads that bound range-day risk and reward
  26. 2016Pre-trade risk-reward versus instinctive exits
  27. 2020Bounding a short-dated option spread with a stop, a gap remainder, and a credit exit
By fieldStops and loss limits76 readingsBy year2001117 readings
All 78 readings tagged Risk-reward ratio
Also on Risk-reward ratio5 readings
1987Precommit the stop and require a surplus payoff1987When open losses overwrite precommitted exit rules1991After a Wyckoff bias, rank leftover cause and keep three-to-one stops1991Ranking month-end holds with risk-reward and stops1992Filter size by expected value and ruin