An important psychological element to long term trading success is understanding your risk appetite. Every trader has a different level of risk tolerance, which essentially means the amount that they can afford to lose on a single trade. It is important to understand this level, in order to deploy appropriate risk management strategies.
The reality is that even the most successful traders don’t earn profits 100% of the times. The reason they are successful is that they understand the amount of risk they are capable of bearing. Calculating the risk/reward ratio of a trade helps traders determine the potential for earning from a specific trade, as compared to the level of risk they would undertake. The key is to enter trades where the potential to gain exceeds the potential for losses.
For instance, your analysis reveals that you have the potential to earn $5 if the market goes in your favour, while you could lose $3 if the market goes against your prediction. Here, the potential return is greater than the potential risk, so it appears a viable position to enter.
It is a good idea for new traders to calculate the risk/reward ratio before entering a trade and placing the stop loss and take profit levels accordingly. If the risk is higher than the expected return, it may be best to wait for the next trading opportunity. Successful traders recommend risking only 1% to 2% of their trading capital on a single trade.