Risk/Reward Error No Trader Can Afford

06/23/2014 8:00 am EST

Focus: STRATEGIES

Price Headley

Founder and Chief Analyst, BigTrends.com

Those who only look at risk and profit target in calculating risk/reward ratio are forgetting a very important consideration-success rate-which can make or break any trade's profitability, notes Price Headley of BigTrends.com.

Think you know about risk and reward? Many traders use the target price and the stop price as their model of risk and reward and leave it at that. However, they may be missing or forgetting about an important risk/reward concept. Read on about this other important component to your trading arsenal.

The concept of a risk/reward ratio is pretty straightforward. For any given trade, you're targeting a certain amount of gain while setting a stop-loss limit if the trade goes the other direction instead. This is a critical concept for any trader to grasp, as the idea is to establish the potential loss to see if it justifies the potential gain. We're not looking at technical indicator or trading-system-based exits here; just a numerical stop-loss.

Of course, in all cases, you want your reward to be at least a little better than your risk, so you set your targets and stops accordingly. A good rule of thumb is to seek a return of three times as much as the amount risked, making the reward/risk ratio three-to-one.

It's equally common, however, to see reward/risk ratios of anywhere between two-to-one and four-to-one. Let's go through a real example.

Say we're buying XYZ shares at $36.00. We think XYZ will move to $46.80 for a 30% gain, and we're willing to risk a 10% loss in the attempt to get that 30% gain.

A 10% loss on $36.00 (initial investment) means shares would fall to $32.40 before we threw in the towel and closed out the position. Our potential reward is 30%, but we're risking a 10% loss. What's the reward-to-risk ratio? Well, 30% divided by 10% equals a three-to-one reward/risk ratio.

So as long as your rewards are bigger than your risks, over time (and enough trades) you'll make money, right? Wrong.

Unfortunately, too many traders automatically set up a three-to-one ratio when setting price targets and stop losses on any of their trades, but they're forgetting something very important. Just because your profit target is three times as big as your risk doesn't mean you'll ever actually hit that target. You also have to factor in the likelihood of a successful trade. Let's take a look at why.

Let's stick with the assumption that our optimal reward/risk ratio is three-to-one. Let's also assume you've developed a trading system (or you're able to pick stocks) that produces one winning trade in every four trades. So, your win/loss ratio is one in four (25%), while your reward/risk ratio is three-to-one. 

Do you think you'll make money with that system? Nope; for every trade that gains 30%, you have three more trades that lose 10%. The rewards were three times as big as the risk, but it didn't create any real profit! The best you could hope for is to break even.

So how does one measure the real reward-to-risk ratio?

You have to factor in the odds of a winning trade into the potential gains or losses. Again, we'll illustrate it with an example.

Say you've found a stock you think will move 20% higher, and you're willing to risk 10% to enter that trade. Your target is 20% above your entry price, and your stop loss is 10% under your entry price. With a reward/risk ratio of two-to-one, this trade doesn't necessarily seem all that great. But what if the trading system had a success rate of three winners for every four trades?

Then you'd have a 75% chance of making 20%, while only a 25% chance of losing 10%. With that particular trade, your real reward-to-risk ratio would be about six-to-one.

The point is, don't fall into the trap of setting targets and stops based on a predetermined risk/reward ratio. Big rewards and small losses are pointless if the system is a net loser.

Rather, focus on the actual risks and rewards of a total methodology-win percentage and average win/loss size are two major components to keep in mind. This will also force you to determine just how successful your trading system or stock picking really is, which is something you should know anyway.

By Price Headley, Founder & Chief Analyst, BigTrends.com

Related Articles on STRATEGIES