The relationship and importance between risk/reward in stock trading
Risk/reward is one of the most important elements of successful trading. A vast majority of stock traders who fail in trading, never get risk/reward right. Either they blow their accounts by focusing solely on the reward or they get nowhere focusing only on the risk.
So, what’s the right balance. How should you approach the risk-reward equation?
Successful trading is always “risk-first”. You must save your capital to be able to keep trading. If you ignore risk while trading, luck will eventually run out and you will be forced to quit.
Most importantly, as a trader, you need to have the mindset of longevity. You can be successful in a few standalone trades by chance, but that isn’t sustainable.
Sooner or later, the law of probability will kick in, and you would be done with trading if you don’t have a well-thought-out risk-reward plan that works in the long term.
Risk in the risk-reward equation
A skilled trader never enters a trade without a stop loss. In the risk/reward equation, the risk is the loss that you expect to take on each trade.
The optimum level of stop-loss differs from trader to trader. A day trader will have a much tighter stop-loss than a swing or positional trader. A leveraged trader will have different stop rules than a non-leveraged trader.
Therefore, you must know your style, timeframe, and strategy to determine your stop-loss levels.
As a rule of thumb, smart traders don’t risk more than 2% of their trading capital on one trade.
For example, if you have a $10000 account and you put $2500 on one trade, you can’t afford to lose more than 8% ($200) on the trade. This $200 is 2% of your trading account.
Reward in the risk-reward equation
The reward in the equation is the return you expect to make in each trade. Like risk, the reward also differs from trader to trader. For example, a positional trader will be gunning for a much higher reward than a day trader.
You can have a set percentage gain plan (for example 10%, 15%, or 20%) or you may have a subjective profit-taking plan based on how the stock behaves after you enter the position.
The important part here is that you must have a profit plan beforehand. There is nothing worse than sitting clueless on a profitable trade.
Risk-reward and win rate - The math of trading
No trader, irrespective of the strategy and philosophy, ever gets a 100% win rate (the percentage of winning trade of total trades). The best traders have a win rate that’s less than 50%. Of course, there will be exceptions, but trading is the game of averages, and a consistently profitable trader always swears by the averages.
When you are trading with such odds, you have to win higher in each winning trade than you lose in each losing trade to take some money home. You need a favorable risk/reward.
Here are different combinations of risk/reward and win rates along with the returns you can expect with these combinations.
In a risk/reward ratio of 1:2, you gain double the amount you lose in each trade. If you trade one stock at a time and put all your money in one trade, with 2%/4% loss/gain, 50% win rate, and 50 trades in a year, you will be up a decent 47% for the year.
With a higher risk-reward, you can log decent returns even with lower win rates. On a 1:3 risk-reward, you walk away with a cool 65%, despite the lower win rate of 40%.
On the other hand, a 1:1 risk-reward with 50% win rate will bring your account down by 20% because losses will work mathematically against you. A 2:1 risk-reward will put you back by 44%.
Even if your risk-reward puts you at break-even, you will still be losing out on trading costs and the opportunity cost of your time and capital.
The Final Word
If you are new to trading, you must have a sound risk/reward ratio that you would maintain based on your strategy, timeframe, and trading style. If you have been trading for a while and not getting the desired results, you must check how your risk-reward and win rate is stacking up.
If your trading statistics aren’t the best and if your strategy can deliver a better risk-reward, you must make tweaks and work on other trading aspects, especially trading psychology and discipline.
If the risk-reward in your trading isn’t good and it can’t get better, you must think of changing the trading strategy to one that offers a better risk/reward.
It’s always a good idea to pull out your trade statistics and analyse your trading performance for what you did right and where you went wrong. It’s only when you do this on a regular basis and document your trades and mistakes, you would be able to bring about the desired change in your trading.
So, pull up your trades now and see how you performed and what led to your performance or non-performance. Check your risk-reward, win rate, and position-sizing over a period.
Double down on the good things and eliminate/change the bad things, that’s how you will achieve super-performance in stock trading.