Calculating Risk/Reward Ratios
Risk to reward ratios. If there is a cornerstone to any trading philosophy, it starts at the risk to reward table.
Although identifying good risk/reward trades does not guarantee success, not identifying good risk/reward trades almost always guarantees failure. Let's explore yet another important subject in the life of a trader and look at a trade setup we took late Friday in the context of this subject matter.
Determining a Good Risk/Reward Trade
Contrary to popular thought, successful traders can take on any type of trade in terms of size and risk as long as they first understand the implications of the trade and are willing to stomach the losses should they occur. If a trader feels that they have the hot hand, they may choose to press a bet (to make a larger than normal purchase or sell on the belief that the odds are in their favor). They do this knowing that they may suffer greater than normal losses if the trade doesn't pan out. Traders do this all the time.
It is critical, if you are to be successful, to understand that trading is a game of probabilities. Technical traders are simply looking for patterns with a greater than 50/50 chance of repeating themselves over and over again. Once such patterns are identified, traders attempt to recognize such patterns in current charts and then identifying entry and exit points based on those charts. Entry and exit points are typically associated with support and resistance areas of the charts. Ah, support and resistance areas. These were the tools of the early traders, traders that read the tape ... traders that were successful at technical analysis long before the advent of all these derivative indicators, these answers to the problem of technical trading, this onslaught of technical wizardry.
The oldest and purest form of technical analysis is support and resistance. Understanding it provides a large portion of the technical analysis that one needs to be successful at identifying entry and exit points.
Calculating the Risk/Reward Trade
In previous chapters we have talked about the need to identify potential trades based on chart patterns. The idea is that you collect a set of candidate charts, charts that have positive prospects for immediate or reasonably near term trading time frames. It is with these candidate charts that one can dig deeper into the possibility of trading that particular issue.
The identification of a probable trade centers around the proper identification of realistic entry and exit positions based primarily on support and resistance. Once you have properly identified the support and resistance points you can take those numbers, plug them into a simple spreadsheet and calculate the risk reward. The simplest form of calculation involves nothing more than the following:
Entry Price
Stop Loss Target
Stop Profit Target
The resulting Risk/Reward Ratio
Now, let's apply this to a particular trade. The following graph shows NEM as it looked on May 17th, 2002. Gold is enjoying a significant run up and this trade actually goes against the prevailing trend, attempting to time a quick short trade based on chart patterns. On the fundamental side, there is concern that gold could continue to rise as the dollar continues to weaken and as world events dictate increased fear on the terrorism front. On the other side of the coin, the technical picture shows a potential short candidate given the annotations provided below.
View image
here.
Given the chart above, here's an example of the most simplistic risk/reward ratio calculation.
In the end, it turns out that world events and the spot price of gold ended up making this trade a losing trade, but risk to reward calculation remains the same ... regardless if the trade wins or loses.
Ranking Trades and the Spreadsheet
To see if a potential play is worth wagering money on, one must determine what the potential losses are if your analysis is wrong, and what the potential gains are if the analysis is correct.
You should always shoot for a minimum of 2:1 ratio, that means that your potential profit should be roughly 2 times your potential loss. This is a rule of thumb that many traders use ... especially the good ones. In the example above, if one enters a trade at the price of $29.12 with a define stop loss exit of $30.68 and a potential target exit for profits at $26, then the ratio is roughly 2:1 (a bit less in this case). That's it. It's really that simple.
Recognize that once one has entered such a formula into a spreadsheet and begins using it, one can easily play with the numbers to make them work. For example, let's say that NEM looks like a great short right now, but that the exit is really $31, not $30.68. Now, one could stretch the target to $25 even though the support lies at $26 in order to justify the trade, but the trader inside you knows this is not the case. When setting support and resistance points, one has to realize that if the numbers are fudged, the person fudging the numbers is the one hurt. It's their money that's on the line.
An easy way around the temptation of making the numbers work, is to always look at the support and resistance points first and allow as much slack in the numbers as makes sense.
Now, plug in the entry price. Does the risk/reward make sense? If it doesn't change the entry price, not the stop or target prices. Jiggle the entry price to the point where it makes sense and then simply wait until you get that entry point or pass the trade up. There are always more fish in the pond.
Once a number of potential trades are identified, the next step is to take a position in the trade. It is important to realize that no trade is a certainty as they are all probability based. The likelihood of success and failure can be quantified to some degree based on certain risk factors. By quantifying the risk factors and ranking the potential trades based on these risk factors, one can take a systematic approach to trading ... an approach that can pay huge dividends. This is a laborious process that takes time and organization. The simplest way to organize this is via a spreadsheet. Since spreadsheets can contain simple arithmetic equations, you can easily build equations to compute the risk factors described below. When first experimenting with trade rankings, one should error on the side of simplicity as having too many factors is no better than having any at all.
So how can you begin to construct a ranking system that allows you to increase your reward and reduce your risk? It's not so much difficult as it is tiring. Looking back, you must first screen a large number of stocks and then flip through a large number of charts looking for technical patterns that have potential. The primary technical indicators you are interested in are those that have the highest percentage of success. Edwards and Magee go to great lengths to point out all types of technical trading patterns in their bible of technical trading, Technical Analysis of Stock Trends .
The obvious factor when ranking trades is to balance the risk versus the reward with the idea that the higher the reward relative risk to the risk, the higher the probability over time that you will make money. The simplest way to calculate the risk to reward ratio, is to pick an entry price for a given stock and then ask yourself, where would you have to consider exiting the stock if it turns out that you are wrong on the trade. For the reward, you ask yourself the same question but the exit is associated with your having a winning trade.
Based on how many shares you intend to trade, you can calculate the amount you will loose and the amount you will win. Don't forget to add in your transaction costs as part of this.
This is the fundamental basis of all ranking systems. From there, you can begin to add other variables such as,
how long do you expect to be in the trade. The shorter the period of time relative to the risk/reward, the more money you can make over time (assuming you win more than you lose).
As your refine your ranking system you will find that stocks with higher betas are naturally more susceptible to short trading periods given their volatility.
Another key variable is a confidence factor. The confidence factor itself if typically based on several factors such as the probability that the technical picture is favourable, the probability of the market contributing to your individual stocks success. Regardless of the factors you experiment with, it is important that you keep your data available for study over time so that you can continue to refine your system. Without constant scrutiny, your ranking system can loose it's value overtime as the markets are dynamic and always changing.
Embellishing the Formula
Once one has mastered the use of the simplest formula for risk/reward, one can consider embellishing the formula to include other criteria. For example, if one could reasonably judge the amount of time it takes a trade to play out, then that knowledge could be incorporated into the spreadsheet in order to rank the trades on a more favourable basis. Think about it.
There is only so much capital to use when trading. Using that capital on the highest potential return over some period of time is the desire.
Another key element of gaining the highest potential return on ones money is to associate a confidence factor into the equation based on the stock, the technical pattern being traded, whether the trade is in the direction of short, intermediate and long term trends, etc. Again, there are a number of factors that can be added to the formula to rank the trades and use that ranking as a basis for decision making.
The desire is to remove some of the gut feeling that goes into trading with a more logical and less emotional process.
Analyzing the Results
Another advantage of plugging numbers into a spreadsheet s that one than then have a historical accounting of trades taken be they successful or not. Keeping ones historical data allows later analysis of that data in order to improve ones performance in the future.
For example, examining historical data to determine where the largest losses were and then deciding if they were because of failed stop exits could provide fruitful insight to changing trading behaviours. The same is true for wins.
Another exercise would be to look over the charts a month after the trade and examine other data points for exits (both success and fail exits). In doing this, one could speculate on what if scenarios such as,
"What if I had maintained the position longer. Would it had continued to perform or would it have turned into a bust?". The imagination can run wild with such scenarios and if you are like most, the amount of time available to ones research is limited to the minimum analysis of old trade data, but there is value in it.
It has been said that if mankind doesn't understand the mistakes of the past then we are doomed to repeat those mistakes in the future. Dwelling on the past is not the issue, but learning from it does have benefit. The game of trading is a lonely game. In today's world it is, for the most part, a game of solitaire where individuals from all walks of life stare endlessly at flickering screens while moving piles of money around. One has to show the motivation to sharpen their game as no one else will.
As we all know, if one is not on top of your game, at least in this game, one doesn't last long.
Summary
Always calculate your risk to reward ratio prior to making a trade. Refuse potential trades unless the risk to reward ratio is 1:2, that is for every dollar risk, there is a potential for two dollars in return. By calculating your risk to reward for every trade you will ignore marginal trades and you will identify your exit points before taking a trade.
Recognize that you want to understand your exit criteria ... at the beginning of the trade, not sometime later. Once you are comfortable with simple risk to reward measurements and are identifying support and resistance zones reasonably accurately, you can consider increasing the complexity of your formula to consider other variables such as time and confidence. Lastly, keep your data points and analyze your successes and failures over time in order to hone your trading strategy.
Article written by Technical Analysis Today - www.tatoday.com
http://www.otrader.com.au/stock_and_option_trading_articles/risk_to_reward_ratios.asp
