-Aug-
09
Portfolio Strategy - Does Improving Your Risk/Reward Ratio Really Increase Your Chances For Profit? (Technorati) Technorati | (Del.icio.us) Del.icio.us | (Digg) Digg | (Blinklist) Blinklist | (Comment) Comments (4)

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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.

4 Comments - Post your comment below.


Nick
Aug. 11, 2006

Hi Chad,

Great article. I definitely agree with you more than I agree with Mr. Woods.

I will enter a trade with an "initial" target price, which as you mentioned is constantly changing. Having "goals" or "rewards" is necessary, but setting the price in stone is where I see a problem. As you mentioned, the markets are always changing - new news, different indicator results, etc. - and as such our strategies need to change as well. Our strategies need to adapt or react.

One strategy I use to adapt to the market is trailing stop-loss. As the price rises, so does my stop-loss. If you're busy and can't watch the trading sessions, and the stock declines, the order will kick in and protect your gains. This isn't a guaranteed or complete solution, but for me it's one way I can hopefully lock in gains.

Good luck on the book giveaway of Trading In The Zone at my TradingWinner.com blog!

Best Regards,
Nick


Chad
Aug. 11, 2006

Exactly my point Nick. Setting a price in stone is a recipe for disaster. Having a general idea of a target price is good, but let's not live and die by it.

Trailing stop-losses are wonderful. Why not give yourself that chance of making more money rather than just selling the stock right away. Let it ride!

I am looking forward to seeing who the winner of the Trading in the Zone book will be. I got my fingers crossed!

Take care,
Chad


Nick
Aug. 13, 2006

Hi Chad,

I'm curious what strategies / indicators / etc do you use to determine when or whether to enter a trade?

Do you do more short term trading or longer term investing?

Best Regards,
Nick


Chad
Aug. 13, 2006

Nick,

I do both short and long term investing. Understand that determining whether to enter a trade and when to enter a trade are two different processes that I handle in that specific order.

Determining whether to enter a trade is first. I look at how the chart is setting up, company fundamentals, institutional cash flow, overall market health and if the risk/reward would be worth my attention.

When it comes to determining when to enter a trade, I do not ever enter any trade unless the price is within two percent of what I determined to be an injection point. The injection point is the point where the stock price touches a critical support level. A stop loss is placed immediately and directly under this injection point because of the enormous selling pressure it would be needed to move the stock another percent or two lower. This of course creates a low risk (high reward) entry point, aka an injection point.

Hope this helps ?
Chad

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