The Professional Stock Trading Approach
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Hi everyone, in this video we look at the Risk Reward element in trading, and how it plays a vital role in any strategy.
First let’s simplify the concept.
It’s widely accepted that in order to increase reward, there is often a need to increase risk, and whilst this simplistic correlation is often correct, a shrewd trader (or investor) can skew the theory, thereby minimising risk and maximising reward.
The closer we can target our trades within this area, the better.
There is however a sad statistic which shows that many new traders trade within this area, with high risk and low reward. We discover shortly how trader psychology can play a significant role in this regard.
Let’s place this concept on to a typical trade example and see how we can skew the ratios into our favour.
First, we have the novice high risk, low reward trader.
A trade is placed against a stock price of $10. The trader chooses not to place a stop loss order, believing that the price will eventually increase to $50.
The trader has therefore accepted to take all of the risk, therefore if price falls to zero, the trader would suffer a 100% loss.
At this stage there is no major concern, the trader has in fact become an investor by taking a buy and hold stance, and should price reach the $50 there is the prospect of seeing a 400% return, or a 1 to 4 risk reward ratio. That would be a good proposition, however the reality is that the novice trader would likely sell a position early, perhaps at $12, with the desire of being right and locking in a profit at the earliest opportunity.
Conversely the novice trader also has a desire not to be wrong, therefore refusing to sell whilst price continues a decline. In this scenario, the trader has turned the risk reward upside down, meaning he is risking $10 to win $2, or as a ratio, risking 5 to return 1.
Remember the mantra of cutting losses short and letting your winners run? Well, here we let the losers run, and cut the winners short, an approach which will likely lead to significant losses in the long run.
As a trader, what we want to achieve is; limited risk, and unlimited reward.
Let’s move from theory to a more practical approach, which is also aligned to my personal strategy.
Being a trader more often than not relies on technical analysis, and I personally look for consolidation breakouts on the weekly chart. And for those interested in such an approach, members have access to our bespoke scanning software which I use to find such set-ups.
Such a set up provides me with the foundation for favourable risk reward. For example, the consolidation area offers rationale to suggest there is an area of support. If, price should break support, we cut our losses. We therefore now have our maximum ‘risk’ portion established.
Let’s assume our breakout candle rises a few percentage points above consolidation, and to keep the maths simple we call the difference between the current price and the bottom of support, 10%.
This now becomes our area of risk. We define this area, or percentage, as 1R.
Over the following few weeks price continued its momentum, increasing by 20%.
Knowing the value of 1R, we can determine that we have gained a total of 2R, providing a risk reward ratio of 1 to 2, therefore risking 1 to return 2.
Now let’s look what would ha