ClearAnalyserRisk/reward and position size for your DEGIRO shares
The risk/reward ratio is the distance from your entry price to your target divided by the distance to your stop: entry €50, stop €46 and target €62 gives €12 against €4, or 1:3. Your position size is the amount you are willing to lose divided by the risk per share: risking €200 at €4 per share means buying 50 shares.
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Stop first, then position
Most investors start with the amount: “I’ll put €2,500 into it.” Start that way and your risk is left to chance. With a stop 5% below the price you risk €125; with a stop 20% below, €500, for the same investment.
The other way round works better. First decide where you are wrong (your stop), then how much you are willing to lose if it goes wrong, and only then how many shares to buy.
Calculating risk/reward
The formula:
risk/reward = (target − entry price) ÷ (entry price − stop)
An example with a €50 share:
| Price | Distance from entry | |
|---|---|---|
| Target | €62 | + €12 |
| Entry price | €50 | |
| Stop | €46 | − €4 |
€12 divided by €4 is 3. You risk €1 to make €3, written as 1:3.
What the ratio tells you
A better ratio means you can afford to be wrong more often. The break-even point (before costs) is risk ÷ (risk + reward):
| Risk/reward | You need to be right at least |
|---|---|
| 1:1 | 50% of the time |
| 1:2 | 33% |
| 1:3 | 25% |
| 1:4 | 20% |
A 1:3 ratio does not prove the trade is good, though. A target of €62 on a share that has never traded above €55 makes the ratio look nice and the odds small. The target needs a basis: a previous high, a valuation, an analyst target you have checked yourself.
Calculating position size
The second formula:
number of shares = maximum loss ÷ (entry price − stop)
This is the standard position-sizing formula (Investopedia: Position Sizing). A common rule of thumb is to risk no more than 1% to 2% of your portfolio per position. With a €20,000 portfolio and 1%, that is €200.
€200 divided by €4 of risk per share is 50 shares. At €50 that is a €2,500 position, or 12.5% of your portfolio.
See what happens when you move the stop:
| Stop | Risk per share | Shares | Position | Share of €20,000 |
|---|---|---|---|---|
| €48 | €2 | 100 | €5,000 | 25% |
| €46 | €4 | 50 | €2,500 | 12.5% |
| €42 | €8 | 25 | €1,250 | 6.25% |
In all three cases you lose €200 if the stop is hit. A tight stop gives a large position. That looks efficient, but a stop inside the normal daily range gets hit by noise. That is the subject of Stop loss or price alert on DEGIRO?.
Also look at what 25% in a single share does to your diversification. How to measure concentration, including through ETFs, is explained in ETF overlap and concentration in your DEGIRO portfolio.
The pitfalls
Costs. Say you pay €3 per order (check your own fee). A buy and a sell then cost €6, which makes your risk €206 and your reward €594. With small positions and a tight stop that matters more than you’d think; see DEGIRO cost overview.
Slippage. A stop loss order on DEGIRO becomes a market order once your level is hit (DEGIRO, Orders and Order Execution Policy). If the share opens 10% lower after bad news, you lose more than your €200. Position sizing protects you on a normal day, not on every day.
Currency. Buy a US stock and your loss in euros also moves with the dollar. Your stop is in dollars; your wealth is in euros.
Average cost. If you buy more later, your average cost changes and so does your risk. Recalculate after every purchase.
How ClearAnalyser calculates it for you
In the Scenario Alerts tab of ClearAnalyser you open a position and drag your stop and target on the price chart. The panel below shows straight away:
- the risk and potential profit in euros, based on your quantity and average cost;
- the risk/reward ratio;
- with the position-size calculator: how many shares fit the amount you are willing to lose.
For a share you don’t own yet it works the same way. Enter an entry price and you see how much you can buy; see also Buying the dip on DEGIRO.
The stop and target you set there are your price alerts too. When the price hits one, you get a Chrome notification; with Premium also an email and an order already filled in at DEGIRO. How to set that up is explained in DEGIRO price alerts. Which other tools offer price alerts is shown in the DEGIRO portfolio tracker comparison.
Frequently asked questions
What is a good risk/reward ratio?
Many investors use at least 1:2. Then you are profitable if 34% or more of your decisions are right, before costs. More important than the number is whether your target is realistic.
What percentage of my portfolio should I risk per position?
A common rule of thumb is 1% to 2% per position. That is the amount you lose if your stop is hit, not the size of the position itself.
Does this work for ETFs?
The maths is the same. For a broad ETF bought for the long term a stop is less common, though; there rebalancing to your target allocation and understanding your drawdown are usually more useful.
Sources: Investopedia: Risk/Reward Ratio · Investopedia: Position Sizing · DEGIRO: Orders and Order Execution Policy (pdf)