Maybe MATH can explain some of it to you in my absence.
Appropriately identifying risk and reward is an important process to complete before entering any trade. You should note the current price and use whatever techniques you favor to determine the direction and extent of the move you're hoping to trade. You should also determine the point at which the market proves you wrong. Once you've done that, your risk is defined to be the difference between the current price and the point at which the market proves you wrong. Similarly, reward is your target price.
For example, last week SEBL was at 13 and had double-bottomed. I thought that it was due for a bounce to about 20. I would be proven wrong at 12. Thus, my risk was 1, reward was 7, and risk/reward ratio was 1:7. This fit my criteria of at least 1:3 and so I initiated the trade.
Calculating a risk/reward ratio is that simple, but it must be done as objectively as possible. In other words, don't let your risk/reward criteria influence your choice of either the risk or reward.
Now, why is my risk/reward criteria 1:3? It's because I figure I will be right about 1 in 3 times I make a trade. Here is what I can expect, assuming 1 trade per month, 5% of my capital at risk on each trade, and wins limited to 3 times risk. I started with $100 to keep percentages easy...
Trade Capital P/L Win?
1 $100 $(5) 0
2 $95 $(5) 0
3 $90 $14 1
4 $104 $(5) 0
5 $99 $(5) 0
6 $94 $14 1
7 $108 $(5) 0
8 $102 $(5) 0
9 $97 $15 1
10 $112 $(6) 0
11 $106 $(5) 0
12 $101 $15 1
Balance $116
Actual results will be different because of the order of wins and losses, but on average, my performance should look similar. I was never down more than 10% and at the end I'm up 16%. Also, in reality losses will never be more than 5% of available capital, but the wins will often be more than 3 times the risk, because I let gains run and cut losses short. This significantly improves performance. Getting one additional trade right results in a better than 40% performance. However, changing one of the wins above to a loss only results in a -4% performance. Getting all 12 wrong in a row with no wins yields a -46% result. Not great, but I will still have 54% of my capital left to work with. This is one way to implement the idea of preserving capital, consistently making money, and still giving myself the opportunity for superior returns as explained in the previous post on this topic.
M |
