Risk reward ratio
The last two illustrations are simulated price movements that shows how it influences our accounts trading two differently priced stocks at a given number of shares. At this point you might already be thinking that lower priced stocks are the way to go for a higher return, If you understand its risk/reward ratio then nothing is wrong trading it. Thinking of a rise from $3.00 to $20.00 should be tempting enough to jump in to that stock at sight. Say, you have $20,000 of investment money, which is cash you wouldn't need for daily or future expenses. Out of that $20,000, you decided that you could afford to lose $2,500 which is obviously your risk and should get you about 833 shares at $3.00. Now, you have already accepted the possibility that you could lose $2,500, you wouldn't be worried as much as actually utilizing the entire $20,000 buying that $3.00 stock, you can increase or decrease the amount of risk as long as it is within your comfort zone. If it does shoot up to $20.00 a share, it will turn that $2,500 into $16,600. Pretty impressive, that is a 560% gain and even if your target price is only $10.00, it would still deliver 233.20% turning it to $8,330 at a profit of $5,830. Dividing that profit with your risk is the Risk/Reward ratio of 1:3.3 for a $3.00 to $10.00 movement.
By now, You wouldn't want to put all that $20,000 on that $3.00 stock because you already know the consequences on both directions as made evident by our last two illustrations. Unless you got another $200,000 stashed somewhere underneath your bed which would render a $20,000 loss moderate rather than devastating, or you just simply like gambling instead of sensible trading. If that's the case losing that much money passing time in Vegas should be a lot more fun rather than spending time betting on something boring looking at sticks and numbers.
Knowing when to exit a trade is crucial. Most securities would not reach a price level that hits your profit target, but it all depends on how far out you're looking at. Your limit could be met if its on a much narrower range. It does not matter whether you're trading a low priced or a higher priced stock when determining your profits in relation to your time horizon. Most stocks above $100 has a rate of change that is way faster than stocks trading below that level, noting that at $100 per share some are even considered cheap when compared to an $8.00 stock. There are several reasons some stocks can't jump from a price of $1.00 to $50, or a $15 stock appreciating to $100 per share, one is the total number of shares outstanding in relation to its current market value. Another is that the company's earnings might be slacking, preventing it's stock price from rising further in value. On the bright side, there are stocks that indeed rose tremendously in value. Some are even on the $200 per share territory and still beat returns from an $8.00 stock within a certain time horizon using a $5,000 investment capital. We'll reveal that on the the next page.