Using these mental stops, rather than hard stops, lets you take advantage of the liquidity of stocks without putting too much of your capital at risk.

 

To calculate risk to reward ratio:

e.g. ABC is trading at $5 and I believe that it has an upside potential of becoming $7. I put $500 into this trade, buying 100 ABC shares. The gain is $2 x 100 shares = $200. Taking the gain, divide it by the capital outlay $200/$500 = 0.4:1. That is assuming I will lose everything of my $500 and ABC will become $0 value. If I have a stop loss at $4, my maximum loss would be capped at $100 ($1 x 100 shares). Thus, my new risk to reward ratio is $200/$100 = 2:1. This means that I might lose $100 to gain $200 in return. If I increase my stop loss to be at $4.50, my maximum loss would be capped at $50 ($0.50 x 100 shares). Resulting in my risk to reward ratio being $200/$50 = 4:1. The potential loss of $50 to get $200.