Wednesday, November 01, 2006

Risk Reward Expectations

It's important to quantify your expectations for how much risk you will take in each position, and how much reward you think that position will offer you. It's also important to follow your stops and your targets, as these reward and risk levels set in place the expectancy you have on the ultimate success of your trading method.

It seems many traders have been so beat up by the market volatility over the last couple of years that they are doubting their methods and looking for new techniques.

The first recommendation I have for you is to read one of Van Tharp's books that deals with the concept of expectancy. The one I read was Trade Your Way to Financial Freedom. Van Tharp is a well-known trading coach dealing with many of the issues most traders most overlook, particularly trading psychology and money management (or as Tharp calls it, position sizing). The concept of expectancy is often misunderstood by many traders, as I get questions all the time asking about my various services winning percentage. Win percentage is half of the equation; the other half is the size of the average winner compared to the size of the average loser. If I can win 5 times as much on average as I lose, then a 1 in 3 winning percentage will still make for a very profitable system over time. This is a typical profile of most options buying systems, as time decay and stops will reduce winning percentage but the size of average winners should be 3 or more time the size of the average loss.

Another key point I took from Tharp's expectancy discussion is that good trading comes down to low-risk entry. This means that you should put your positions on at points at which you will know quickly whether you are right or wrong. If you are wrong, that's OK, but the key is to be wrong in a small way, take your loss quickly and get out. If you are right, then you can have the 10-bagger or more situation where you are winning more than 10 times what you could have lost. That again allows you to take a series of small losses and still make money over time.

As far as trading techniques that give me a positive expectancy over time, here are some of my favorite indicators that allow me to define the best opportunities:

1. Efficiency Ratio
2. Stochastic Confirmation
3. Average Directional Movement
4. Momentum Divergence
5. The Volatility Index (VIX)
6. Open Interest Patterns

Click the Risk Reward Expectation header link above to learn more about Dr. Van Tharp's excellent books on money management, position sizing and much more.

Good day and good trading.