Are the Hard and Fast Rules of Trading… Really That Hard and Fast?
After my recent webinar held with NetPicks, I have and continue to receive quite a few emails. The questions are all over the map but two show up in just about every single email:
- What is the risk/reward ratio?
- How much to risk per trade?
Those are fair questions. After all, every single trader has had those two items pounded into their heads time and time again. While it is easy to rattle off the usual answers, it is really too simplistic. After all, positive R/R ratios are not the grail to a successful strategy, nor is risking 2% per trade.
So what is the correct answer to each of these questions?
Let’s look at risk to reward.
If I take a trade where the risk is $100 and the reward is $300, what is the ratio? I am sure you said the risk to reward is 1-3. Is it? Out of those two-dollar amounts, what is the only true definite? The risk amount. The reward amount is potential, what you will shoot for. It is not a definite amount. So if the only definite is my risk, what good is that number? On the surface it makes sense. Make sure your wins are multiples of risk. In actuality, it really doesn’t show the effectiveness of your strategy. Well, what does? While you may not want to totally discard risk/reward ratios for the sake of having a rule set, there is something else you may want to keep your eye on. (Having a high reward to risk based on market structure can increase the probability of making money but is beyond the scope of this article)
The key for me and has been for years is keeping your eye on the average profit made over a series of trades. In no way did I invent this. I was first exposed to it years ago by Van Tharp. Here is the calculation:
Average Profit/Trade =
(Probability of Win * Average Win) – (Probability of Loss * Average Loss)
Let’s assume you have a strategy that wins 70% of the time. Assume your average win is $400 and your average loss is $800. Most would discount a 1-2 reward to risk strategy.
Plug in some numbers:
(70% * 400) – (30% * 800) =$40.00
Even with a negative R/R, this strategy will still make money. Play around with that calculation and you may be shocked at how a low winning rate can still make you money.
How much to risk per trade?
Since we are talking about risk as well, what is the amount you should risk per trade? 1%? 2%? Sorry, once again there is no straight answer. There are many factors that go into your decision including your comfort level AND your strategy. There are some setups that I play where I have risked in the low double digits simply because the probability of making money on it are great. It may be prudent for those new to trading to stick with the often-touted percentages set in the rules of trading. When to increase your risk percentage is a pretty advanced approach to trading. If not done properly, you will hand your broker your account faster than you actually funded it.