Follow us on Twitter @Schwab4Traders. This blog updates the first Tuesday of the month; next installment publishes December 11thh.
Many novice traders begin each trade by anticipating the money they’re about to make. It can be easy to ignore the risk of a trade, but it’s also a mistake. A trader should always consider their downside risk and compare it to their opportunity for profit.
If you’re risking a dollar to make a dollar, you could be right half the time and not be profitable. This is where many new traders get a little off target. Perfection in trading is not the goal. In fact, over the long term, most traders are right about half the time. The use of a proper risk:reward ratio in your trade strategy will allow you to be wrong, even frequently, and still profit in the long run. If you could be right as few as three out of ten trades and still profitable, would you want to? Absolutely! Take the burden of accuracy off your shoulders. Let’s break down how using a 1:3 risk to reward ratio can help your risk management.
At the most basic level, a 1:3 risk:reward ratio has your risking $1 to make $3. Let’s say you’re a trader of XYZ and have noticed it has been in a sideways range for a few weeks between about $9 and $13. Your analysis has your entering long trades at $10 with a stop at $9 and a limit exit at $13 ($1 downside, $3 upside). You buy your shares at $10 and place a stop order at $9 to protect your position.
Over a few weeks, you traded XYZ ten times, always buying 100 shares at $10 and always selling at either $9 or $13. You inaccurately timed seven of those trades and lost $100 each time (-$700), but managed to be correct in your timing three times, profiting $900 total. Ten trades, 70% wrong, but you’re up $200 total. Of course, this is a simple example and most of our trades will not be clear cut like this. However, this is why building the risk:reward ratio into your trade plan can be so helpful.
Using this ratio can help you to walk away from a poor trade setup or encourage you to buy at a limit price below the market to improve the ratio. It can also be a good way to define your trading success. If you’re actively trading a balance of $100,000, how should you evaluate your results? Should you expect returns equal to the broad market like the S&P or the Dow Industrial Average? I suggest not. The broad market returns are benchmarks for allocated and diversified portfolios. A trader should establish a plan and then define success by adhering to their plan. The trade plan is your roadmap to long term profits and successful trading. Sticking to your own rules will give you the results for which you’re striving.
Schwab’s Gain/Loss Analyzer tool was built to help you keep an eye on this with all your equity and ETF trades.
Source: StreetSmart Edge®
In the above screenshot taken directly from my trade history, we can see these ideas at face value. For this window of time, I closed 24 total trades. 14 were for a loss while only 10 were for a gain, so less than my 50% average. Yet, I was profitable by $900 because my average gain was 9.6% while my average loss was only 1.8%. This is a better ratio than my 1:3 target but exactly what I’m trying to accomplish.
The most important aspect of using a proper risk:reward ratio with your trading is sticking to it and carrying your trade to its natural conclusion. Use stop orders or brackets to make this process easy and keep you from making decisions in the moment. The decision you make while watching the stock’s price tick higher or lower is unlikely to be a sound, quality decision. Build your trade in advance, know your exit points and stick to them.