Tuesday, October 31, 2006

Risk Reward

Think you know about risk and reward? Most traders use the target price and the stop price as their model of risk and reward, and leave it at that. However, they may be missing an important risk/reward concept. Read on to add a new weapon to your trading arsenal.

The concept of a risk/reward ratio is pretty straight-forward; for any given trade, you're targeting a certain amount of gain, while setting a stop-loss limit if the trade goes the other direction instead. This is a critical concept for any trader to grasp, as the idea is to establish the potential loss to see if it justifies the potential gain. Of course in all cases, you want your reward to be at least a little better than your risk, so you set your targets and stops accordingly. A good rule of thumb is to seek a return of three times as much as the amount risked, making the reward/risk ratio 3 to 1. But it's equally common to see reward/ratios of anywhere between 2 to 1 and 4 to 1. Let's go through a real example.

Say we're buying XYZ shares at $36.00. We think XYZ will move to $46.80 for a 30% gain, and we're willing to risk a 10% loss in the attempt to get that 30% gain. A 10% loss on $36.00 (initial investment) means shares would fall to $32.40 before we threw in the towel and closed out the position. Our potential reward is 30%, but we're risking a 10% loss. What's the reward to risk ratio? Well, 30% divided by 10% equals a 3 to 1 reward/risk ratio.

So as long as your rewards are bigger than your risks, over time (and enough trades) you'll make money, right? Wrong. Unfortunately, too many traders automatically set up a 3 to 1 ratio when setting price targets and stop losses on any of their trades. But they're forgetting something very important. Just because your profit target is three times as big as your risk doesn't mean you'll ever actually hit that target. You also have to factor in the likelihood of a successful trade. Let's take a look at why.

Let's stick with the assumption that our optimal reward/risk ratio is 3 to 1. Let's also assume you've developed a trading system (or you're able to pick stocks) that produces one winning trade in every four trades. So, your win/loss ratio is 1 in 4 (25%), while your reward/risk ratio is 3 to 1. Do you think you'll make money with that system? Nope - for every trade that gains 30%, you have three more trades that lose 10%. The rewards were three times as big as the risk, but it didn't create any real profit! The best you could hope for is to break even.

So how does one measure the real reward-to-risk ratio? You have to factor in the odds of a winning trade into the potential gains or losses. Again, we'll illustrate it with an example. Say you've found a stock you think will move 20% higher, and you're willing to risk 10% to enter that trade. You're target is 20% above your entry price, and your stop loss is 10% under your entry price. With a reward/risk ratio of 2 to 1, this trade doesn't necessarily seem all that great. But, what if the trading system had a success rate of three winners for every four trades? You'd have a 75% chance of making 20%, while only a 25% chance of losing 10%. With that particular trade, your real reward-to-risk ratio would be about 6 to 1.

The point is, don't fall into the trap of setting targets and stops based on a predetermined risk/reward ratio. Big rewards and small losses are pointless if the system is a net loser. Rather, focus on the actual risks and rewards of a total methodology. This will also force you to determine just how successful your trading system or stock picking really is, which is something you should know anyway.

Good day and good trading!