It is common for many new traders to get involved in a trade simply thinking about the additional money they stand to make. An average profit of ₹2,000 looks enticing but a more important question needs to be asked: how much are you willing to give up in order to land that very same trade?
What this is where risk / reward balance comes into the picture. This is just simply compares how much you could potentially lose, with how much you are expected to gain if your trade goes according to plan.
For instance, assume a trader takes a position that has a potential loss of ₹500 with a potential profit of ₹1,000. The ratio of risk to reward is 1:2. The trader risking ₹1 for a potential profit of ₹2.
It doesn’t mean all 1:2 trades will be winners. Markets can go against your edge, that is why they are called “edge markets” and even a good setup can lose. But if you think of risk-reward ration, then having a balanced system means the one loss can’t destroy your account.
The most drastic change, as I see it, is when you move from “How much can I make?” to “Is the potential reward worth the risk I am taking?”
That little change can dramatically improve decision-making.
Some traders have no idea about risk-reward and assume that the best trade has a higher ratio. They will try to find 1:5 or 1:10 trades everywhere without asking if the target is realistic.
Say you plan to risk ₹ 500 in a trade and then try to make ₹ 5000. On the face of it the reward seems brilliant. But if the market structure is not right for such a large move, it‘s just a pipe dream.
The best risk/reward plan a trader can use is one we can come up as it all depends on the markets structure, not your greed. Support, Resistance, Strength of trend, Volatility and the way the markets have been moving can lead us to work out if a target is viable.
For example, if the resistance is very close to your entry, a big move up doesn‘t seem quite logical. A more conservative and realistic target could be better.
The same idea stands for stop-loss placement. Don‘t set a stop at every distance for the sake of forming a nice ratio.
First understand the trade setup then find the reward and risk.
If the target is small the risk will be small; hence the better trade is the one for which the reward justifies the risk of the trade.
Risk-reward is just one section of how you effectively trade. How much you buy or sell may entirely alter how the very same setup work.
Let’s say that two traders find the exact same trade. Both are offering a risk of 1% and a target of 2%. A box ratio. However, if one of the traders is opting for a larger-than-needed position, a marginal move in the asset is going to be emotionally charged.
Therefore position sizing should be tied into how much you can stand to lose.
The simplest way is to determine your maximum acceptable loss ahead of time. Then work out your position size based on the distance your entry is from your logical stop-loss.
For instance, if you‘re willing to assume a risk of ₹500 and your stop-loss is at a distance of 10 from your point of entry, your position size should be based on that risk, and not randomly selected.
This properly sort of makes buying and selling rather more methodical.
In my experience, many trading problems are not due to the strategy...they are simply caught by the trader because the position size is too large compared with the account size.
Even if the setup is good, a bad position size will turn it into a bad trade.
One of the more common misconceptions that can be found is to assume that every losing trade signifies that the strategy is no longer profitable that is not the way that probability works.
A sensible trading setup can have a run of many losing trades. It‘s whether the overall setup has a reasonable edge over a large enough sample of trades that counts.
Here‘s a sample: Suppose a trader is risking ₹500 to potentially make ₹1,000 then five losing trades would result in a loss of ₹2,500. A single winning trade would result in a profit of ₹1,000. A few successful trades out of the group could eventually cover losses.
Some factors which will influence trading results include, win rate, fill, costs, slippage and changing market conditions, so nothing is ever guaranteed.
The key point is that one trade should not form the basis of your opinion about a system.
This mentality also makes it less likely for traders to increase their positions after a losing trade. It usually starts when a trader is trying to recover funds from a loss.
Rather, every trade should be seen as a single event in the context of many other insignificant trades.
Think in terms of process and chance rather than individual wins and losses.
The number one thing you learn when studying trading is that making money can be a matter of ensuring that your losing trades are small enough to survive.
A trader can be making losing positions and still consistent if the risk is being managed. But not one ‘big’ trade can ruin a few months effort.
Before entering a position, I would keep a simple checklist:
Let‘s look at the following entry:
Would be use of logical stop-loss.
Where should I aim for?
How much ad am I putting at risk?
First, a key concern is each IM‘s individual level of reported confidence and if that is sufficient to, in effect, justify the reward we have to (elementally) hope is there. To illustrate the question this implies, would the reward still be acceptable if the IM is as low as 0.25 and its most frequented option is 0.4?
Am I taking the right position size?
Even though these questions seem very simple, they can help avoid emotional decision making.
Never use risk-reward as a magic formula. It is merely a set of guidelines for risk to reward versus opportunity.
This is not going to be useful because trade after trade is not likely to win. The goal is to be disciplined long enough for a good strategy to be profitable trades over.
This is the reason many seasoned traders, trading at a professional level, are more concerned with how they react to what they predict will happen than on trying to predict what the next candle will be.
Long-term consistenc is about capital preservation.
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