After determining that a potential trade has an acceptable risk level, we also need to figure out whether the possible reward is worth the risk.
What is the possible reward ?
In other words, if the trade moves in our favor, how far is it likely to go ? Absent a shock of some sort, stocks tend to move between support and resistance. One way to pick an initial target is to locate a point just inside the next level of support or resistance. The distance between that point and the entry is the “likely reward”. The potential reward could be much greater, but in this step just figure out what’s probable.
Is the likely reward worth the risk ?
Unless you have a really high batting average (say 70% +), it seldom makes sense to take a trade which has more risk than the probable reward. The lower your batting average, the greater the possible reward needs to be relative to the known risk. A lot of traders (myself included) like to have at least a 2:1 reward / risk ratio before taking a trade. At that rate, you only have to be right half the time or less to be profitable over time. A 3:1 or higher ratio is certainly desirable.
Profit = Gains - Losses
Profit = ( %wins * average win ) - ( %losses * average loss )
So, for a 55/45 hitter with 2:1 reward / risk average
Profit = ( 0.55 * 2 ) - ( 0.45 * 1 ) = ( 1.1 - 0.45 ) = 0.65 risk unit profit per trade, over time
(this is the expectation formula. I will likely revisit it in the future, and it will be on the final exam, lol)