Risk vs Reward Trading
The key to outperforming the markets is making sure time and
time again you are taking favourable risk reward setups. By this I mean,
entering a trade where you believe the stock will trend enough to outperform
the risk you have on the trade. For example, a stock comes up in your chart
scan and looks like it has a reasonable chance of trending in the coming days.
You need to plan the risk (Entry to Stop Loss) against where you think the
stock will move too (Reward). I will only take trades where I believe the
reward outweighs the risk taken. I’m not looking to make a 1% return from a 1%
risk. I’m looking to make a 5% return from 1% risk if possible.
Now, everyone has a different view of the market and will
trade different setups accordingly. One of the traders I look too, Mark
Minervini says he is right 50% of the time, whereas I’m only right about 30% of
the time. His average risk to reward is 1 – 2. This means every 1% he risks, he
will make 2%, 50% of the time. A phenomenal outcome. The way I trade is
slightly different (and I am always trying to improve my statistics).
For every 1% risk I take, I will a make 3.24%, 30% of the time. I would love to
be right 50% of the time, but I like aiming for a higher risk reward ratio which often results in a lower win percentage. The
lower the risk to reward percentage often results in a higher win percentage. However, you must ensure you keep achieving a strong win percentage otherwise you risk having poor performance. I will delve into performance statistics at a later date. Let’s
now return our focus to risk reward trading.
To find a favourable risk to reward setup, I perform a scan
on my charting software. I scroll through the weekly charts and pick out the
best stocks that are trading above their 13 week moving average or just
slightly below and add them to my watch list. Once I’ve finished my scans, I
will review all the trades and look for consolidation patterns that may offer a
chance for a continued trend. Once I have established the best looking setups,
I will zoom down to the daily chart to define the trend, and then from then on,
I will monitor the stock on the daily and hourly time frame and look for an
area that will provide me with a strong risk to reward ratio. Here are a few examples of what I am looking
for:
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| Small pop above 13 week MA & then consolidation |
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| Waiting for stock to form a defined setup |
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Opportune entry for defined risk
|
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| Pops above 13 Week MA and consolidates |
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| Forms defined setup |
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Refined entry for favourable risk reward opportunity
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Stock trading above 13 Week MA - strong trend
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| Refining the setup |
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| Fine tuning entry for favourable risk reward |
Of course finding risk reward trade setups in real time is a lot more difficult than looking at trades in hindsight due to your emotions and current performance levels. However, this is the basic premise for how I try to outperform the markets. What I haven't mentioned is how the markets trade through 'windows of opportunity' whereby trending stocks are more plentiful. You need to recognise when the windows are open and when they aren't. This is something I'm still continuing to improve on and a topic I will discuss in due course.
