STEP-6: Correct risk/reward ratios
We know we need to budget for 40-50% of our trades not going our way. Therefore, the only way to ensure our strategy has a positive expectancy (it’s a strategy that builds profit over time) is to ensure our gains from the winners add up to more than the losses from our losers.
Rather than rely on luck and hope, we can program this into our strategy by ensuring our trades all have reward/risk ratios exceeding 2-to-1 or preferably 3-to-1. This means the distance from your entry to your profit exits needs to be 2-3 times the distance from your entry to your abort stop.
Here’s another way to think about it. Why risk a 5% loss (stop) to only make a 5% gain (your target)? That’s a 1:1 reward/risk which is silly. You may as well go play Roulette!
Let’s relook at that hypothetical trade from Part-4:
In our hypothetical example above, we are being told that this trades’ reward/risk ratio is 2.9-to-1, which is the distance to the Donchian 80-day high (our target) divided by the distance to our Donchian 10-day low (our stop).
If you always configure trades with 3-to-1 reward/risk ratios, then you could have only 30% of your trades winners and you will still come out ahead in the strategy if you persisted! You can lose 3 times in a row and win on the 4th trade (25% win rate) just to recover all your losses with a 3:1 reward risk ratio.
With a 2:1 reward/risk ratio in your trading regime, you could literally throw darts at the stock pages in the newspaper to select your shares, which statistically should give you a 50/50 chance of a winning trade, and your winnings should be double all your losses (theoretically of course!)
This is why it is so important to identify exit levels UPFRONT and more importantly, STICK TO THEM!
With JSW-Online, Sharenet Analytics traders can click one button and only be shown opportunities that have a minimum 3:1 reward/risk ratio. This can save many hours in trying to identify the right trading opportunities.
To see a 30-min video summarizing the last two sections with real-world examples, of using Donchian stops and exit targets and risk/reward ratios, see this video
Dwaine van Vuuren
RecessionAlert, Sharenet Analytics
Dwaine van Vuuren is a full-time trader, global investor and stock-market researcher. His passion for numbers and keen research & analytic ability has helped grow RecessionALERT.com (US based) and PowerStocks Research (now Sharenet Analytics) into companies used by hundreds of hedge funds, brokerage firms, financial advisers and private investors around the world. An enthusiastic educator, he will have you trading and investing with confidence & discipline.