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The Tao of Reward and Risk
by Sam Eder
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On the surface, reward vs. risk seems simple. Just make sure you have a three to one reward/risk ratio and — hey presto — you can go back to searching for that perfect entry.
But like so many trading concepts, what seems simple actually has a lot of depth, plenty of room for mistakes, and great opportunity. A superficial understanding of reward/risk just won’t do it justice. We need to look closer to ensure our trade management is as good as it can be.
The Basics: Reward/Risk Ratios
Knowing the reward/risk ratio of your trades should be one of your bread and butter trading activities. For every trade, either know the answer or ask the question -
What is your potential loss compared to your potential gain?
For example, some traders like Paul Tudor Jones look to make five times their risk on each trade which gives a reward/risk ratio of 5:1. Others might look to make an amount equal to their risk, giving them a reward risk profile of 1:1. The point is not necessarily to pick one or the other — that comes later, when you set your trading system’s objectives — but to make sure you know the reward/risk of the trade you are about to place.
Traders can develop unhealthy habits in their obsession with having a high reward/risk ratio (3:1 is a common one). Certain behaviors can prove less than helpful for good trading results. For example, it’s no good sticking a profit target three times the distance of your stop away from your entry and simply hoping that is enough to make your trading system profitable. Instead, the reward/risk profile of the trade should be carefully considered based on the opportunity presented in front of you and how you implement the trade to produce the best outcome.
Focusing on an overly simplistic view of reward/risk can also lead the trader into doing things backwards. A backwards example - some traders will simply place a stop-loss very tight to the entry just so they can have a suitable reward risk ratio based on a good target, but this is putting the cart before the horse. Tightening the stop to manufacture a superior (or even acceptable) reward/risk ratio does not work. You can’t turn a poor opportunity into a good one by simply moving the stop closer to the entry. In fact, if you think about it logically, it makes sense to have the stop further away on a lower quality trade as a tight stop is highly likely to be triggered.
Instead, wait for opportunities with naturally high reward/risk profiles and then place your stop where it is most likely to achieve your trading system’s objectives. (For Van Tharp students — this is what he means when he talks about having a 3:1 reward/risk ratio. Find opportunities that have a naturally favorable reward/risk profile, rather than trying to manufacture them.)
Reward/Risk vs. Win Rate
Setting your system’s reward/risk profile is a balance between consistency (win rate) and profitability (reward/risk). A system that makes less profit but is easier to trade because it wins more often can be a better choice for traders over a trading system with more losing trades but bigger winners.
To alter the reward/risk ratio, you could stalk an entry point on a lower timeframe, which will improve the payoff and lower the risk. Conversely, you could widen the stop-loss, which will decrease the reward, but increase the win rate. Neither of these adjustments, however, will ever turn a bad opportunity into a good one or vice versa. They are just going to allow the trader to meet different objectives, whether the aim is to create an easier system that wins more often therefore is easier to trade, or a more profitable trading system with larger winners (that could be more difficult to trade).
Ways of Calculating Your Reward/Risk
Another area where an overly simplistic view of reward/risk falls down is assessing the reward/risk profile of a trading system. Instead of generically thinking about reward to risk, consider three distinct measures:
- Targeted reward/risk
- Current reward/risk
- Effective reward/risk
Targeted reward/risk is what we commonly refer to as the reward/risk ratio. It is based on the reward/risk profile of the trade prior to entry. For example, if you are looking to make 3 units for every one unit you risk, then your targeted reward/risk ratio is 3:1.
The current reward/risk is the live reward/risk profile of your trade as it changes throughout the lifecycle of your position. For example, you might start with a targeted ratio of 2:1, and then after you are in the position, you adjust your stops, take profits, or add size to the trade as part of your trade management rules. As the live trade progresses, the current reward/risk profile may vary drastically. (One note — Van recommends that you never let your current reward/risk ratio to decline to less than 1:1 while in a trade.)
Improving Reward/Risk Ratio vs Static Reward/Risk
The effective reward/risk ratio is your ending reward/risk profile across a number of trades.
For example, your average winning trade in a system might be three times larger than your average losing trade. In such a case, you might have a targeted reward/risk of 2:1. If your average loss is 0.3 and average win is 0.9, you would divide your average win by your average loss to reveal an effective reward/risk of 3:1 — substantially better than it the initial or targeted reward/risk ratio. Of course, you might have the reverse. A system that targets 3:1 could end up with an effective risk reward of 1.5:1 or worse.
It gets really interesting once you start running comparisons with win rates factored in. For example, would you rather have a trading strategy that makes +0.9R on average and loses -0.3R on average (for an effective reward/risk of 3:1) with a 60% win rate, or a system with a targeted reward/risk of 3:1 and a 40% win rate?
Without a detailed knowledge of reward/risk, many traders would choose the system with the 3:1 targeted reward/risk and 40% win rate. But if you grasp the concept of effective reward/risk analysis, you might find the system that makes 0.9R just suits you better. It would probably be easier to trade so you would make fewer mistakes and the resulting higher quality would allow you to trade it with more aggressive or more creative position sizing strategies.
Scaling-Out: Accepting a Lower Reward/Risk Ratio on Part of the Trade
When looking at the reward to risk profile of a trade, you need to consider the whole trade including all its component exits. Sometimes it may make sense to accept a lower reward to risk on part of the trade, as long as the reward to risk on the trade as a whole remains at an acceptable level.
An instance of this would be scaling out of the trade as the market continues to moves in your direction and the trade has reached some profit target. In this case, your reward to risk profile is less than optimal on a part of a trade. But this sacrifice of the reward to risk profile may improve your trading performance in other areas. For example, taking profit out of a trade at various points may help you meet a trading objective for generating a smooth equity curve.
How about your trading? What reward/risk ratio do you think is acceptable on your trades? Do you have a defined targeted ratio before you enter a position and an acceptable effective ratio resulting from your trades? Do you manage your current reward risk ratio on open positions? Developing a strong and deeper understanding of your reward to risk management can be a great edge and a path to trading mastery.
About the Author: Based in New Zealand, Sam Eder trades currencies using rule-based discretionary systems. He has studied Van Tharp’s trading principles extensively over the last 10 years and incorporates many of those when writing his daily blog posts on his Forex signals service FX Renew.
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NEW! Swing Trading Video From Ken Long
In this half hour video recorded on Sunday, February 21, Dr. Ken Long went through the top 15 or so swing trade opportunities his analysis found for the upcoming week. Regardless of the setup reason and intended trade direction — long or short, Ken gives serious consideration to trade scenarios in both directions given the current conditions in the market. Ken has said that he attributes 95% of his trading success to his preparation processes and you can see how such preparation gives him a substantial edge.
Dreary with Occasional Upside Snaps
by D. R. Barton, Jr.
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A quick quiz: Since 1993 (when the S&P 500 ETF, SPY started trading), when have the biggest up days happened in the markets? Some logical choices might be during the run-up to the Internet Bubble in 2000 or the run up to the Real Estate and Credit Bubble of 2007.
But if you’ve read articles in this space for any length of time, you know that I write a lot about the importance of monitoring the volatility in the market and in particular, the volatility in the instruments you trade. In fact, I’ve written 15 articles since 2008 for this very space with the word “volatility” in the title!
And if you’ve read any of those articles, you’ll know that big-time volatility happens in down markets. Here’s the real kicker:
*** Huge up days happen almost exclusively in down markets. ***
I know that that you’re not going to just take my word for it, so don’t worry. As usual, I’ve brought the numbers with me to back up that bold (and bolded) statement. Let’s jump in and see how 19 out of 20 of the biggest up days since 1993 were relief rallies during market swoons.
The Numbers, It’s Always About the Numbers
After slogging through the data and comparing every daily percent change in SPY, here are some number facts about the biggest up day and down day on record since the inception in January of 1993 of the S&P 500 Index based ETF:
- SPY’s biggest single up day: +14.52%, October 13, 2008
- This happened the day after the market finished having one if its biggest collapses in history losing 34.4% in just 16 trading days.
- The second biggest one-day gain happened just a couple of weeks later — an 11.69% jump on October 28, 2008.
- The biggest down day of the last 23 years? Not surprisingly, it was October 15, 2008 when SPY lost 9.84% in a day.
Now let’s look at all 20 of the biggest up days of the last 23 years
- The Real Estate and Credit Bubble Collapse: Biggest gain numbers: 1 – 6, 8, 11 and 18 (nine in all) happened in the five-month period of October 2008 to March 2009 during the bottoming process in the biggest down market since the Great Depression.
- The Internet Bubble Bursting: Biggest gain numbers 7, and 14 – 17 (five in all) happened in 2001 and 2002 during the bear market that followed the Internet Bubble.
- The Long Term Capital Management Financial Scare: Biggest gains numbers 12 and 13 came as rebounds during the demise LTCM and the global scare that resulted in September and October of 1998.
- The Asian Currency Crisis: Biggest gain number 10 came as a rebound from the currency crisis in 1997 known as the “Asian Contagion”.
- The S&P Downgrade of U.S. Credit & the European Debt Crisis Kick-off: Biggest gain number 20 came near the end of the rapid drop in August 2011 that followed the downgrade of U.S. Sovereign debt.
- During the Internet Bubble: The last two are a bit of a gray area, coming in the first quarter of 2000. Biggest gain number 19 came just 6 trading days before the S&P 500’s March 24th top. However, it resulted from the January – February correction (-10.4%) and so can easily be classified as a relief rally from a market drop.
- Biggest gain number 9 came on January 7th, 2000 as a response to a three-day 7.5% pullback that happened to kick-off the New Year. I believe this is the only daily gain in the top 20 biggest gains that can be classified as happening during flat or up market conditions.
There you have it – 19 of our 20 biggest up days all happened as pops immediately after or during significant market drops.
As we remain in corrective market territory, don’t be surprised to see aggressive rips to the upside. And because of the global macroeconomic problems that we discussed last week, don’t get your hopes up for an easy recovery out of these lower levels any time soon.
Please let me know your thoughts and opinions on the article. Send your comments to drbarton “at” vantharp.com – I always enjoy hearing from you!
About the Author: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena. He is a regularly featured analyst on Fox Business’ Varney & Co. TV show (catch him most Thursdays between 12:30 and 12:45), on Bloomberg Radio Taking Stock and MarketWatch’s Money Life Show. He is also a frequent guest analyst on CNBC’s Closing Bell, WTOP News Radio in Washington, D.C., and has been a guest on China Central Television — America and Canada’s Business News Network. His articles have appeared on SmartMoney.com MarketWatch.com and Financial Advisor magazine. You may contact D.R. at "drbarton" at "vantharp.com".
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February 24, 2016 #773
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