Ever felt you are getting enough trading calls right, but aren’t still making significant profits? An unfavourable risk-reward ratio could be the answer. At the outset, we want to mention that trading is inherently risky and requires, in addition to deep understanding of chart patterns, a lot of discipline. Be advised that trading is not a quick way to make money. A trader must not have irrational expectations (starting out with Rs 1 lac and hoping turn it into Rs 10 lacs in a year). In order to make quick money or recover losses incurred, traders sometimes take excessive risk. Such trading is akin to gambling and is equally harmful to your finances as gambling is. Retail investors find it difficult to separate emotions from trading and are averse to book losses. They exit winning trades too early and stay in the losing trades for too long. Therefore, we do not recommend active trading to retail investors. If you are willing to take such risk, we suggest you work on your skills of technical analysis and allocate only a small portion of your investable funds towards active trading. In this series, we will not focus on technical analysis but shall focus only on the discipline aspect of trading.
What is risk and reward?
We start with the importance of getting the risk reward ratio in a trade right. Risk means the amount of your money you are willing to put to risk in a particular trade. For example, if you buy a stock for Rs 100 with stop loss of Rs 90, the maximum risk for you in the trade can be Rs 10. Reward is the potential profit that you can make from the trade. So, if your target price for the above stock is Rs 115, the reward is Rs 15. The stop loss and target levels shall be decided before entering the trade. In this example, the risk reward ratio 1:1.5 (Rs 10: Rs 15).
The stop loss levels (for limiting losses) and target levels (to book profits) are not based on whims of the trader and have their basis in the theory of technical analysis. Stop loss levels should ideally be determined based on support levels on price/volume charts. Target price can similarly be determined by identifying a resistance zone on the charts. Support/resistance zones are price levels where demand/support of a security increases to halt price decline/advance. Previous peaks and bottoms on price charts are potential support and resistance zones. Identifying support and resistance zones for a stock is beyond the scope of this blog post. You may refer to various resources available on the internet for better understanding of technical analysis and support/resistance zones.
The minimum risk reward ratio
Having the correct risk-reward ratio for any trade that you plan to enter is a must if you want to be a successful trader. The potential reward to the maximum loss in a trade should always be in excess of 1.5 (2 is ideal). The target profit from the trade shall be at the least 1.5 times the risk taken in the trade. You may be adept at reading chart patterns but if you trade with an unfavourable risk reward ratio, you are headed for big losses on your trading portfolio.
Let’s illustrate this with the help of an example. Suppose you enter 10 trades. You put an equal amount of Rs 1 lac in each of the trades. You have 1000 units of 10 different securities at Rs 100 each. Additionally, you have kept a risk-reward ratio of 1:2. This means you will exit the position if the stock drops to 90 or if the stock hits 120. Even the best traders will find it difficult to get more than 6-7 trades out of every 10 trades right. Let’s assume you get 6 trades right.
As is evident from the above example, you have made Rs 80,000 or 8% by just getting 60% of your trades right. Now let’s reverse the risk reward ratio to 2:1. This means you will exit the position if the stock drops to 80 or if the stock hits 110.
You have incurred a loss of Rs 20,000, even though you got the same number of trades right. The above example illustrates the importance of getting the risk reward ratio right before entering the trade. Even though you got only 60% of your trades right, you ended up netting a decent 8% return because your risk reward ratio was favourable.
You may have the ability to identify a lot of winning trades. However, you will still be sitting with heavy losses on your trading portfolio at the end of the year if your risk reward ratio is not right. In the same example, if your risk reward ratio was 1:3 and you got only 4 out of 10 trades right, you would have still ended up making 6%. Surprised. You are making money even when you got more than half of your trading calls wrong. By opting to enter trades with favourable risk reward, you increase your odds of making money through trading.
Recommended Trading Process
Please bear in mind target and stop loss levels have to be decided before you enter the trade. So, the trading process should be like this.
- Identify a favourable chart pattern based on your technical analysis skills.
- Decide upon the stop loss and target levels.
- Enter the trade only if the risk reward is favourable.
- Once entered, keep the emotions out and stick to the trade plan
We advise against entering the trade with an unfavourable risk reward ratio no matter how good the chart pattern is. This is because chart patterns do not succeed all the time and have a probability of success attached to them. This is the reason even the best traders do not all their trades right. However, they are smart enough to cut their losses when the trade goes wrong. So, once you have entered the trade, keep emotions out of the trade.
In this blog post, we have highlighted an aspect of trading that is often neglected by traders. Trading discipline is as important determinant of trading success as technical analysis skills are. A favourable risk reward ratio will increase your chances of trading success. Happy Trading!!!
Deepesh is Founder, PersonalFinancePlan.in