Portfolio Strategy - Does Improving Your Risk/Reward Ratio Really Increase Your Chances For Profit?
I recently read an article by Mr. Phillip Wood discussing Risk/Reward Ratio's and how trading this strategy can help increase your profits. Mr. Woods states:
If you are risking more in a trade than you stand to make in profits, you are setting yourself up for failure. Imagine you are interested in buying a lottery ticket for a jackpot worth $1 million. So you drive over to the convenience store to buy a ticket, but the price of one ticket is $2 million. You can’t believe your eyes. Who in their right mind would pay $2 million for the chance to win $1 million? In disgust, you turn around and promptly storm out of the convenience store. Unfortunately, however, there are a lot of traders who buy the $2 million ticket on a regular basis. They do so by risking more in a trade than they stand to make in profits. They risk $2 to make $1.
While I agree with most of the article and practice this strategy, there is one major difference between Mr. Wood and myself when it comes to determining an appropriate Risk/Reward ratio. That difference is that my reward is constantly changing, either for the good or bad, based on what the stock and all the other technical indicators are telling me. My pre-defined target price can change at any time.
Mr. Phillips goes on to explain the system:
Having a positive risk/reward ratio will do two things for you. First, it will increase you profit potential. Second, it will make it easier emotionally to take follow your rules and take losses when you should. It is much easier to take a $1 loss on a trade when you expect to make $2 on your next trade.
Improving your risk/reward ratio when you are buying a stock is quite simple. All you have to do is make sure you buy the stock when it is closer to support than it is to resistance. For example, assume a stock you want to buy is priced at $35. You determine you would have to set your stop loss at $32, and you anticipate the stock will rise to $40. If you were to enter this trade, you would have a positive risk/reward ratio. You would be risking $3 (the difference between your entry price of $35 and your stop loss of $32) in order to make $5 (the difference between your entry price of $35 and your profit target of $40). That would give you a risk/reward ratio of 1:1.67.
However, if you only thought the stock was going to rise to $37, you would have a negative risk/reward ratio. You would be risking $3 (the difference between your entry price of $35 and your stop loss of $32) in order to make $2 (the difference between your entry price of $35 and your profit target of $37). That would give you a risk/reward ratio of 1:0.67. You have stacked the odds of success against you, and you should consider passing on this trade.
While I think the idea looks good on paper and is a great fundamental concept to consider before entering into any stock position, I feel there is one major flaw here. Can you guess it?
The major flaw I see is trying to predetermine your exit point. For example, you enter into a stock at 10, a stop loss at 9 and a target price of 13. This gives you a 1:3 risk/reward ratio. The stock then proceeds to climb to $12.50 before abruptly turning south again. If you fail to recognize this reversal, then you have failed to lock in the profits already made because you are still waiting for the stock to hit that magic 13 number instead of paying attention to other technical indicators like volume. This would have signaled to you that now is a good time to lock in your profits. The stock turns south and falls all the way to 8 and you got at 9 for minus 1 dollar/share loss.
My main point here is that while I agree with putting the odds in your favor, buying on support and selling on resistance, sometimes we need to be a little more flexible than the article suggests. Instead, I suggest following your stocks closely and watching for signs of either weakness or growing strength. You don't want to sell the stock at 13 just cause that is what looked good 5 months ago. The stock could go to 20 for all you know.
Again, as Mr. Wood suggests, buy on resistance and don't enter a trade where your risk/reward ratio is not at least 1:1 (even through I prefer 1:2). When it comes time to sell, I pay attention to the technical indicators, not some pre-determined number that looks good at the time I purchased the stock.