I think your Risk/Reward calculation is a bit misleading. The obvious inference is that you can improve the ratio by either reducing your stop loss or increasing your target price. Either of these could result in disaster. A better way of looking at risk and reward is to include some assessment of the probability of the SL being breached and of the target being reached.
For example, you might conclude that, based on the figures you mentioned, the probability of 820p being breached was 20%, but increasing the SL to 850 would increase the probability to 50%. Similarly, it seems logical to assume that the higher you set your target price, the lower the probability of achieving that figure. At the price quoted by Paul (862p) you might assess that the probability of reaching 900p was 75%, but that would decline as the target price increased. You might conclude that the probability of reaching 1080 within a reasonable timescale was only 35%. This would give (for want of a better term) a Probability Ratio of 35/25 or 1.4.
In the figures I have given, the Probability Ratio for a target price of 900p with a SL of 820 (ie a small, quick profit) would be 3.75. If the SL was reduced to 850 the Probability Ratio would give a negative for a target of 1080 and a ratio of 1.5 for a target of 900p.
This approach gives a more realistic assessment of the risk involved, but does require an estimate of probability for the target and SL.
Time is definitely another factor but maybe we're talking at cross purposes. My post was trying to introduce a method which gave a realistic estimate of the probability of a trade succeeding.
Your calculation seemed to imply, especially to someone without experience, that the probability of success in the trade is about 73% - and if you're getting that sort of success rate, can I shadow you? Mine implies a success rate of about 40%.
I've no doubt that your experience tells you the true probability of success and the Risk/Reward ratio as you define it is a useful tool, but it doesn't show the overall risk of a trade. Trader 333's post also introduces some caution by highlighting the percentage of successful trades.
PS - I lived in Ruddington until middle of last year. Small world - just what is the probability of that?
Money management is king. In the land of the trader, money management has ruled and killed all the traders who don’t believe in it.
This is nothing new, but few new traders use money management wisely and get “killed” because of it. There is a myth among new traders that you HAVE to be right more times than wrong. This table is one that I’ve taken from “The Master Swing Trader” by Alan Farley:
What the table shows is that to be profitable, or more profitable, you can either work on being right more often, or reducing the losses. Most new traders will let their losses run and run, which means the trades that follow must be right to claw back the money they have lost.
This is a table that Chris Manning displays, and it really shows the importance of cutting your losers
<table border="1"> <tr><td>% loss   </td><td>% gain needed<br>to break even</td></tr> <tr><td>10%</td><td>11%</td></tr> <tr><td>20%</td><td>25%</td></tr> <tr><td>50%</td><td>100%</td></tr><tr><td>80%</td><td>400%</td></tr> </table>
It shows that the higher the loss the significantly higher % gain it takes just to get back to square one.
The most effective way of controlling your trades is to look at the risk / reward ratio of the trade before you enter into it. This is done by setting a rough price target, and knowing the position of your STOP. From this you can then work out the risk / reward ratio, for example
Current price = 100
Target = 109
Stop = 97
Reward = 9 points
Risk = 3 points (including commission).
Giving a 3:1 ratio
Knowing where to place the stop is a difficult thing, but the rule of thumb is that the stop is placed at the point the chart tells you “you are incorrect” Most people (including myself) rarely take anything less than a 3:1 ratio, especially for stocks. A 3:1 ratio means that you only have to be right 25% of the time to break-even.
Once your in a trade one of 3 things can happen, Either your stop gets hit, the price moves sideways or the price moves into profit. The first 2 you can’t really do much about, but when a price moves into profit, then you move the stop to lock in some profit. This is an art form in itself.
The important thing is to make sure that at any one point, the risk should not be equal or greater than the reward. In the above example, if the price went to 105, and we didn’t move the stop we would have this scenario.
Current price = 105
Target = 109
Stop = 97
Reward = 4 points
Risk = 8 points
Giving a 1:2 ratio
This is where moving the stop to lock in profits really comes in. If we move the stop to 102, we lock in 2 points worth of profit and have the following risk / reward
Current price = 105
Target = 109
Stop = 102
Reward = 4 points
Risk = 3 points
Giving a 1.3:1 ratio, which is a lot better than the 1:2 ratio we had earlier.
Moving stops, and stops placement is very difficult, but I will hopefully find someway of explaining it next week.
If we have a look back at the chart of AAL from last week, we can see that at the close on the 24th January we would have had this risk profile.
Current price = 874
Target = 930
Stop = 859
Reward = 56 points
Risk = 15 points
Giving a 3.73:1 ratio, which is good enough for me
The other aspect of money management is the stake size. I know a few traders who’s stake size is too large for the account they are trading. The important thing, especially when you are first starting out, is to make sure that you “Stay in the Game” as most of your learning will come when your actually trading.
The accepted level of risk amongst the professional traders and the trading authors is 1% of your capital on every trade. I used to trade with 2% risk, but that was far too much, and it still scares me today to think that I actually had that risk!! When your risk increases, any bad run that you have will be magnified beyond your control.
Here's my take on BAY. I haven't done TA on EOD stocks for a long time so don't take this as gospel, but follow the reasoning..... Firstly, one of the powerful TA formations is Negative or Posative Divergence- go look this up in the archives if you don't undertand the terminology.
Secondly, there is a rule that says 'history repeats itself, and each instrument has it's own characteristics'.
So here we have BAY showing Positive divergence in the price. NOW go back in time and see if the price responded in the past to Positive divergence. Answer, yes it did on at least one occaision.- Around Nov 1999 - look back further at your leasure. Notice also there was a responce to Positve Divergence in July 2000.
OK so now we have that bit done. We can assume that the price is now more likely to go up than it is to go down ( Is that a wise assumption in this climate?). OK let's go long, but what about the R/R? The risk is a drop below 100, so that's 14p. Give yourself some breathing space so say 95p....19 p away from 114p. The reward is , worst case, is 141p- downtrend resistance. You CAN'T assume the price will go beyond this value. That's a reward of 27p. So the R/R is 1.5. That's just no good at all , especially as you have a potential BIG drawdown of more than 10% to get to support.
Now here's the crunch. Patience.Why not put it on your "watch list" for a price of 145p? There is a triangle formation that may break to the upside through 150p. At this point we have a viable trade. The risk will be the value of the downtrend resistance line, which after the breakout will become support! This will be in the order of 140p. The reward will be around 190p, horizontal resistance, as drawn. This gives a R/R of 4:1. 10p down , 40p up.
You may think this is tedious, but it will win hands down over the "pin the tail on the Donkey"
An alternative possibility. Go long now, on the basis that the price IS at support, on a minor uptrend. Stop at 105p R/R is 2.5 :1. Not my cup of tea .)
If you didn't read it, take a look at my Dow analysis on Friday under Indicies. The Dow had a nice R/R 8:1 on a triangle breakout.
First things first. Chartman, I can tell it’s been a long time since you traded EOD. Line charts are fine for 1 minute data, but useless for EOD charts - Unless your one of these newspapers who enjoy doing a dot to dot chart on the FTSE 100 to show all the people in the street what has happened
Thank you for your kind comments, and for any new traders out there, I think Splurge sums up how important this subject is.
What JonnyT is saying is that the price has dropped quite a way and eventually the selling pressure runs out and people start buying it back up again, and after a major sell-off, you don’t want to be shorting because it could turn at any time. In the short-term it looks like it might bounce, and as Chartman pointed out there is some divergence. Which is something I will be looking at in a couple of weeks time.
Chartman makes a very good point. As I just said, we can’t really go short, and as Chartman says, the risk is too high to go long. We can’t trade BAY at the moment, so we look for a “Safe entry” or a point at which the risk / reward ratio comes into our favour. This is where the waiting comes in, it could take weeks for the price to enter a safe trading zone, but then the markets reward good safe entries, and not the gun-hoe approach.
My personal view on the chart is this.
The support level (Which now becomes resistance) is at 130. So say the price hit 130 and started to fall again, to say 125. If you short at 125 then the risk / reward profile looks like this:
Entry Price: 125
Target: 100 (the last low)
Stop-loss: 133 (3 points slippage to give the price space to move around).
Giving a ratio 3.125:1
Getting to grips with Risk / Reward is hard, and its something that is not learnt overnight, so if anyone wants help with Risk and Reward, then post up a chart with your view on the risk and reward, and I’m sure someone will have useful comments to add. Remember we are all here to help each other.
Fluke, try your hand at the chart for BOC over the last 7+ months. Post a chart up, and we’ll see how you get on. Remember there is no wrong answer. If you would rather not post up a chart (and this goes to everyone) then feel free to email me at [email protected] , but if you can post a chart up, then others can learn from it as well
It's interesting to note my first resistance lines on the first chart
line up with the Fib lines on the second chart.
It looks like a reversal is taking place possibly on the strength of the positive survey carried out by Opodo ,an online travel service,
I cant thank you enough,I have understood you explanation,this is exactly what i need to get my head round. I will look at the BOCchart and come back to you.By the way,I thought the 130 level was resistance,you said it is support. Im not criticising you,just making sure I understand how you work.
I think one important lesson to come out off the last series of postings is the fact that not trading is sometimes hard to do.
I wonder how many people studied your chart and were desperate to find an excuse to trade it.
Beware of trading for trading's sake. I think the post by chartman highlights this, we all need to sit on our hands sometimes and wait and watch.