Capital Management – Risk/Reward Ratio

Today we conclude the Capital Management series by discussing point number 4;
  1. Determine your risk sizing
  2. Identify your stop price or where you will exit if the trade goes against you
  3. Calculate your position size
  4. Examine the risk/reward profile of the trade before entering
Professional traders spend more time thinking about how a trade could go wrong and how they should manage it, rather than about how much money they stand to make if it goes right. That said, it is still important to work out an exit strategy should the trade go your way - before you enter the position. Furthermore, a trade setup needs to offer a suitable risk-reward ratio in order to warrant taking the trade in the first place. There is no point risking $1 to make 50c. Not unless you have a 67%+ strike rate. I have met some traders over the journey who have a 10% strike rate (i.e. they get 10% of their trades right) but a risk/reward ratio of 1:20 or 1:30. That is, they will only get one in 10 trades correct but, when they do hit a winner, they will make 20-30 times what they are risking. These guys are very intense. They have to be to tolerate long losing streaks. Most retail investors can’t and won’t tolerate that much losing. It’s not good for the psyche and requires patience and discipline beyond the capacity of most people. A good trader could safely assume a strike rate of between 50-60%. That’s where most successful traders live. That being the case, the risk/reward ratio needs to be greater than 1:1. A 1:1 risk/reward ratio across a set of trades, with a 50% strike rate, is a breakeven proposition in terms of trading results. It would actually a loss in the real world when you add in fees. A 1:1 risk/reward ratio would probably need a 60% strike rate to break even, when factoring in fees. That sort of strike rate is at the upper end of what a retail trader should expect and would be difficult to sustain. So, how do we make the numbers work? We need to up the risk/reward profile of the trades. Traders should be looking for a 1:1.5-2 risk/reward ratio on their trades, assuming a strike rate in the 50-60% range. Not every trade will work out like that but if individual trades are set up with this in mind, they will be more likely to produce favourable outcomes. Across a set of trades, the sum total is these outcomes are far more likely to be profitable overall. Here is an example of what this looks like at the level of an individual trade; Risk reward of a trade Above is chart of BHP, which has just suffered a sharp pullback. It has caught some support around 3400c and is bouncing. Whilst it would be an aggressive trade, one can make the case for buying from an oversold level. A stop-loss 15% below the 3425c entry price would see it placed at 2911c.
  • 3425c x 0.15 =514c
  • 3425 – 514c = 2911c
We then use the 1:1.5 risk/reward multiplier to see where a potential target would be.
  • 514c x 1.5 = 771c
  • 3425c + 771c = 4196c
As can be seen on the chart, 4196c is just above the latest swing high but within the highs from May/July. It is not unrealistic to think that the stock will trade back to this point – from a technical perspective only - the fundamentals/global headlines/macro impacts and 1000 other factors might tell a different story. We’re simply concerned with the risk/return profile of the trade we are considering, based on the technical elements of the setup. In this case, with this setup, it passes the test. Sometimes it won’t and the trade can be taken anyway. If you are wanting to buy a stock that is hitting fresh all-time highs for example, then this basic assessment will have no relevance. This is why it is the last point in the checklist and why it does not override the previous elements. It is really a check and balance to make sure that you are not taking too many trades which don’t have the risk/return profile to make your trading style work. In other words, if you are constantly risking too much to make too little, it won’t matter how good your strike rate is, the basic math won’t stack up, and you won’t make any money. Cheers, Chris Conway

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