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Risk and Reward – All that Should Matter to a Trader

Category: Trading Risk

Overview of Risk and Reward

Trading is not as complicated as everyone would have you to believe.  Successful trading comes down to whether you can turn a profit.

Getting to the point where you can consistently land in the black will take some time.  For some of you, you may never reach this point in your trading career.  However, with a ton of courage, positive thinking and a sound trading system, you can beat this the greatest of all games.

Now, back to my earlier point, trading is not that hard.  When you really dummy it down, the one question you have to ask yourself is if you can manage your money properly.

Forget all of the indicators, predictive analysis, automated trading systems, and high-speed fiber connections.  Are you able to effectively manage your money on every trade?

To this point, being able to determine the appropriate risk reward ratio will in the end be one of the key factors if not the only factor which will determine the length and success of your trading career.

In this article, I will cover the concept of risk and reward and how essential this basic ratio is to your overall trading strategy.

When should you apply the Risk and Reward Ratio?

If you do not know the answer, then you clearly were skimming the introduction of this article.

Before we even get into the details of the risk and reward concepts, I want to make it very clear up front that this is required for every trade.  Meaning, before you click buy or sell short, you must have both your profit target and stop loss exit identified.

If you are unable to or are unwilling to determine your risk and reward on each trade, STOP TRADING!

I normally do not go for the shock and awe when discussing the markets, but without knowing your risk and reward you are just setting yourself up to fail.  I don’t know about you, but failure is not an option.

How to Determine the Risk and Reward Ratio

There are many complex calculations and formulas in the financial markets; however, risk reward analysis is not one of them.

Risk Reward Calculations

Profit is defined as your profit target minus your entry price.

Stop Loss is defined as your entry price minus your stop loss price.

You then take the value of the reward/risk to come up with the reward to risk ratio.

If that was not confusing enough, let’s take it to the charts to further illustrate this point.

reward and risk
Reward and risk

In the above example, let’s assume you entered ICLD at $2.86.  You want to place your stop beneath the recent swing low of $2.85, so you enter a stop loss order of $2.83, which is 1% beneath your entry price.

Based on previous price action, you are confident ICLD will go 4% higher from your entry price; therefore, you enter a sell order at $2.98.

Therefore, you are risking 3 cents ($2.86 – $2.83) in hopes of making 12 cents ($2.98 – $2.86).  Hence, you have a 4 to 1 reward to risk ratio.

What is the Best Risk to Reward Ratio?

This question haunted me for many years.  The most common ratio you hear is 1 to 3, meaning for every dollar you risk expect 3 dollars in profit.

The harsh reality of trading is that the numbers never work out this cleanly.  Based on the volatility of the stock, or the amount of dollars you are using in the given trade, your ratio may differ.

What I will say is that while you may have different ratios based on the trade setup, over the aggregate of your trades, you should average somewhere between 3 to 5.

This can feel a bit high, but you have to stack the chips in your favor for long-term success.

Seems so straight forward, well let me further explore how the simple risk reward ratio perplexes even the best of traders when it comes time for execution.

Traders are Unwilling to Commit to a Profit Target

Take the ICLD example, cited in the earlier section of the article and assume you do not sell at $2.98.  For whatever reason, you believe that ICLD will go higher and guess what you are right – well initially.

ICLD after a nice pop over $3 begins to retreat and ends up pulling back to under $2.98.  Don’t believe me; well let’s skip forward in time using the Tradingsim time machine to check out the action.

not honoring profit targets
Not honoring profit targets

Now that ICLD retreated to $2.91 cents if you were to sale, you would have made 5 cents while risking 3 cents.  Not to make this sound horrible, because you still would have a reward to risk ratio of 1.667; however, 1.667 is not 4.  This delta represents an almost 60% profit margin loss.

Take this lack of discipline to commit to sell and apply this over a random distribution of a hundred day trades.  How are you able to effectively run your trading business, if you do not know what your true profit margin is on each trade, because you change the profit targets after entering a trade?

Traders are Unwilling to Commit to Stop Loss Orders

Similarly, to our previous example, but on the other side of the equation, traders also struggle with honoring their stop loss orders.

We’ve all been there, the stock is not acting appropriately and yet we hold on.

Call it greed or the need to be right, for whatever reason we know we should exit the trade but do not.  To make matters worse, instead of just doing nothing and letting the stop trigger, we will either cancel the position outright or change the entry price.

You may say to yourself, well, what’s the big deal if I change the orders on a few trades?

Well, in our previous example, if we expect to have a 4 to 1 reward to risk ratio and then we lower our stop loss, we are eating into our profit margin.

Still not feeling the pain?  Let’s once again take it to the charts.

not honoring stop loss
Not honoring stop loss

ICLD ended up failing and retreating not only below your entry price, but also breached the swing low of $2.85.  So, a trade where you could have had a 4% gain, resulted in a 3.5% loss.

I wanted to walk you through this example to illustrate that if you do not define the boundaries of gains and losses, you are unable to manage your money properly.

Also, imagine the emotional turmoil you will put yourself through as you go from a winning trade to a losing trade for no other reason than your inability to manage your money.

You Need to Start Thinking Like a Business

Let’s step away from trading for a minute and put the concept of risk and reward in other business terms.

Amazon just crossed the mark of becoming the largest retailer in the world surpassing Walmart.  Even though Amazon is in everything from bedding to handheld devices, do you think for a second that Amazon doesn’t understand their profit margins on every item they sell?

For example, Jeff Bezos may know he is making 8 dollars on every Elsa Frozen doll sold.  Now, imagine if one of the retail managers decides to sell the doll for 7 dollars less, without modifying the purchase agreement with Amazon’s supplier.  Jeff would have gone from 8 dollars in profit down to 1 dollar.

Take this example and imagine if this was sort of price manipulation was done arbitrarily across the millions of products Amazon offers.  Do you think Amazon would be the number one retailer in the world if they did not have discipline around profit margins?

How do you expect to make it as a trader if you don’t do the same?

Risk and Reward in terms of Dollars not Percentages

Up to this point, we’ve talked formulas and how to execute a proper risk to reward trading approach, but we have not talked in dollars.

There is one point I really want to drive home in this article and that is that you have to think in terms of dollars.  Now, if you are a trader that uses the same amount of money on every trade, then you can skip this section of the article and feel free to browse one of our related posts.

However, if you are a type of trader that adjusts the amount of dollars used based on the volatility of the stock or key support/resistance levels and things become a bit more complicated.

Let’s say you average a 3 to 1 reward to risk ratio, but you use varying amounts of money on each trade. This figure may shift more dramatically with day traders, as they are able to closely monitor price movement intraday.

At any rate, by using different investment amounts, your 3 to 1 ratio may tell a different story in terms of risk to your portfolio.  This over a sample distribution of a few hundred trades will actually show you that you are risking more than you think.

The simplest way to address this is to have a set amount you are willing to risk and make per trade in terms of dollars.  For example, if you want to risk 1% ($1,000) of your portfolio per trade in hopes of making 3% (3,000) of your portfolio per trade, then you could have any one of the following scenarios listed below:

  • Invest $100,000 with a 1% stop and a 3% profit target
  • Invest $50,000 with a 2% stop and a 6% profit target

I think you get the point.

What you don’t want to do, citing the previous examples, is start to occasionally using $100,000 and hope to make 6% and risk 2%.  This high risk high reward approach will make it difficult to accurately track the exposure of your trading decisions and will put your trading business at risk.

In Summary

If you have any plans of trading long-term, then you absolutely have to think and operate in terms of risk and reward.  This golden ratio applies to all forms of trading (i.e. day trading, swing trading and long-term investing), so please do not buy into the myth “no risk no reward”.

Much Success,

Al

In this article, I will be covering 6 trade management strategies for preventing traders from taking all-in trades. Before I dig into the details of each step, let us first come to an understanding of what is an “all-in” trade.

What is an all-in trade?

All-in Trade
All-in Trade

The way I am framing “all-in” for this article, is where a trader is looking to strike it big overnight.

For my riverboat gamblers and traders that laugh at the idea of stops or money management, all-in trades do not require a definition because it is such common practice for your trading styles.

For those of you out there that are unfamiliar with the term all-in, it essentially means you have committed so much of your capital to one position, that the position can literally make you or break you.

When I say, “break you”, I am not implying a slight bump in the financial road. I am saying your account will literally go from $100k down to $20k in a short period of time.

This brings me to my next point regarding all-in trades. These are high volatility trades where a stock can move up or down quickly. For example, pouring all of your funds into a new IPO of a small company or backing up the truck on a biotech awaiting phase 3 approval from the FDA.

Even for blue chips, which may seem infallible to the risks of an all-in trade, below is a list of sure stocks that ended up ruining people’s lives:

  • Enron
  • Lehman Brothers
  • Global Crossing
  • World Com

Now that we are all grounded on what is an all-in trade, let us start digging into the 6 steps that can save you a lot of headache.

Step 1: First understand how you let the trade get out of hand

This may sound like an unnecessary step as you are presently in the trade and seeing how the past can help at this point can feel like a waste of time. However, it is important to know how you have ended up in an all-in trade, in order to navigate your way out of such a precarious position and to ensure you never commit such a trading error in the future (Step 6).

Please take a few minutes to examine each scenario provided below to identify which scenario best fits your situation. This will be critical later in how we deal with the root cause of the issue, so we can eliminate this destructive behavior pattern from your psyche.

Scenario 1 – Did you open the position in hopes of hitting it big with a home run trade?

Home Run Trade
Home Run Trade

You need to realize that there are no free lunches in the market. For every stock that soars 400%, there are another 100 that do not come anywhere near those types of returns. Seeking quick gains is a sure way to hand over your hard-earned money to traders that are more skilled.

Scenario 2 – Did someone else talk you into taking the position and you felt like it was such a sure bet you could not stop yourself from making the easy money?

Taking advice from others can feel like the right thing because it transfers responsibility of your trading actions onto someone else. Making money this way will feel great when things are going your way; however, the minute things go south, you will be frantically looking for a life raft. The reason being, you never fully understood why you were taking the trade in the first place and without a winning attitude and nerves of steel, the market will always find a way to separate you from your money.

Scenario 3 – Did you start out with proper money management techniques, but kept averaging down on the trade so much that you found yourself with a concentrated position?

This is likely one of the toughest root causes for being over leveraged. You were fighting the market, or trying to average down and things got out of hand. You were not looking to strike gold or using someone else’s advice to make it big. You were simply trying to manage your way out of a bad situation and things got worst.

Do any of these scenarios sound like you or a variation of you? Please remember to be honest, as you are thinking through how you ended up all-in on the trade.

Step 2: Embrace the Risk or Fold’em

The decision my friend is never easy, but must be all yours and no one else’s. The logical response to holding an all-in position is to fold’em and live to fight another day. However, what if you have already taken a sizeable loss in the trade, or what if you have played it safe for years and you are willing to take the risk on this one stock.

Regardless of how afraid you may or may not be, the key is taking a stance and sticking to it no matter what.

If you elect to reach deep and let it ride, then let it ride. You cannot begin second-guessing yourself and overreacting to every tick. If you micromanage the position, you will find a way to sabotage the trade and completely ruin your potentially life changing event.

If you elect to close the position or reduce your exposure (highly recommended for any long-term trading success), then do so and never look back. Do not take the conservative route and then monitor your old position everyday as if you are still in the trade. Especially do not beat yourself up if the stock actually goes to the moon after you closed or reduced your position. Remember, large winning trades can still be bad trades because you violated your rules.

Step 3: Learn to Manage Your Emotions

You are going to have a heightened sense of emotions like those that you have not felt before in your life when holding an all-in position. Your emotions will ride up or down based on how the stock performs on a given day, hour or even minute. The grip the position will hold on your life is indescribable.

So, as you are reading this article, remember there are really two emotional levels you will have to endure:

  • the short-term emotional swings you will experience while holding the position
  • after the position is closed you will need to emotionally accept the outcomes of your poor decisions (good or bad)

Step 4: Have a set exit target

Trading all-in will bring about the greed and fear in your soul as if you are being chased by a bear in the wilderness. The only way to control this is to have a set target where you will exit the trade no matter what.

Now, if the trade is not working out, your target will likely be somewhat realistic as you have been humbled through the experience. If you are on the other side of the trade and things are going well, you will start to develop such lofty targets that your future rewards will be hefty enough to take care of your family for generations to come.

So, herein lies the challenge, how do you effectively set a target that will make the risk worth your time?

I cannot answer this one for you, sorry. The best thing you can do is set a realistic target, enter your order and when that number is reached, exit the position and never look back.

For me, I would use a point and figure target and choose the lowest achievable price target as my first level to consider exiting the position. Once the target is achieved, I would then watch the stock like a hawk to determine when to exit the position.

Step 5: Immediately take a break from trading

After you close an all-in trade, you will need to take a break from trading. Homerun trades not only work a number on your bank account, this type of trading behavior will also take a toll on your personal well-being and will negatively impact your closest relationships.

The other reason for taking the break is you need to grasp the horrible position you placed yourself in, regardless of the root cause. Obviously, if the trade went against you, you may feel like you need to just checkout to build back up your confidence. However, if the trade is wildly successful, this is also a reason to take a break from the market. Inexperienced traders lose the most money after reaching a euphoric peak in their account balance.

Trust me when I say the money will leave you just as quickly as you were able to earn it if you do not take a breather.

Depending on the level of risk you were carrying should dictate the amount of time you step away from the market. If things really got out of control, you should likely take 2-3 months to clear your head and to work on setting up safeguards, which we will cover in the next section to ensure you eliminate that part of you that takes all-in trades.

Step 6: How to implement safeguards so you never take another all-in trade

Man in the Mirror
Man in the Mirror

When I was in my early 20s, I had a concentrated position in Dow call options back in 2003. I literally had an opportunity to turn $40k into over $2M in a little under 12 months. Needless to say, greed consumed me and instead of taking $250k to over $2M by executing my trading plan, I decided to chase a few more thousand and ended up missing my life changing opportunity.

After blowing this trade, I still dabbled in options until late 2006 when I managed to blow another $25k. After this blunder, I found myself looking in the mirror and asking the tough question of “what the hell are you doing?”

The fact I was even asking myself this question led me to close out my options account. I knew then as I know now, options trading brings out the greedy part of my psyche, which is not conducive to making consistent money.

I began to embrace the fact that time was on my side and with a sound investment strategy, I can accumulate significant wealth without the stress.

Now that you have listened to me on my soapbox, let us talk through some basic steps you can take to prevent yourself from going all-in on a trade.

Remember in Step 1 where we identified a number of scenarios leading to all-in trades, well now we can start to peel back each one to provide steps to prevent their occurrence in the future.

Scenario 1: Did you open the position in hopes of hitting it big with a home run trade?

If this is you, your issues are not with trading, but something else in your life. Either you are seeking a quick thrill or the idea of freedom has you taking unfathomable risks in the hopes of hitting it big. While this can happen, the odds are not in your favor. Below are some of the reasons in your mind that could be pushing you to take the home run trade:

  • You believe you are special and will easily climb into the top 1 percent of all earners without doing much work (this should strike a chord with any millennials reading this article)
  • You are not satisfied in your job. Like many people, your job provides you sustenance for survival but is not your life’s purpose. The idea of hitting it big and telling your boss to pound sand can take you to some pretty far heights in fantasy land
  • The idea of taking years to build up your trading capital feel like a waste of time

If this is you, the first thing you should do is stop trading for 2 to 3 months. You need to figure out why you are really in the business of trading. There is trading for a hobby or cheap thrills and then there is trading for a living. As long as you continue to swing for the fences, there will be disciplined trader on the other side of the trade to take your money.

Scenario 2: Did someone else talk you into taking the position and you felt like it was such a sure bet you could not stop yourself from making the easy money?

These are the worst type of riverboat gamblers in my opinion. Not to beat up on this group too much, but if you are going to take huge risks with your own money, do not take the coward approach and use someone else’s advice.

If you fall into this category below are a few steps you can take to ensure you never end up in an all-in trade again:

  1. Cancel all stock advisory subscription services
  2. Stop cruising chat rooms and social stock sites looking for hot tips
  3. Remove margin from your trading account if swing trading
  4. If day trading, only use 10% of your available trading margin on a position

Scenario 3: Averaging down has gotten completely out of control

If you find yourself all-in on a position because of averaging down, below are some simple trade management techniques you can use to get back on track:

  1. Stop averaging down; your issue is with identifying the appropriate entry point.
  2. Accept that a percentage of your trades are just going to be losers. Averaging down is another way of saying you have to be right on every trade.

Now that I have listed the 6 steps for how to effectively manage an all-in trade, I now need to take a quick detour and go on a personal rant.

All-In Trades Rob Us of Great Traders

As we mentioned earlier in this article, trading is one of the few professions that you can commit a disastrous act in seconds that can ruin years of hard work. This sad reality I believe robs the trading community of great talents on a daily basis.

It pains me when I encounter traders that can go on a 6-month run and then lose it all and more in a week.

It is one thing if a trader will never achieve their dream, but for the trader that is so close to touching the mountaintop, only to be slapped back by a trade that got away is something I hope we as a community can help defeat.

The Literary and Blogging Community Also Needs to Take Some Responsibility

I get that the internet is meant to be the ultimate destination for freedom of expression, but there are social and moral obligations that we as a trading community need to start holding authors accountable to.

My loving wife, who continues to support me through this journey of mastering trading, sent me a link to an article the other day about the top trading hoaxes for 2014.

The Forbes article titled ‘Top 5 stock market hoaxes of 2014’ did a great job of quickly describing how a few so-called traders were able to deceive so many.

Out of these stories, 3 of them really got my goat. The first was a story of a kid that somehow managed to make $72 million trading while still in high school. Another one talked about the penny stock Cynk that went from a non-existent valuation to over $6 billion. The last described how a blogger/writer for Street.com and Seeking Alpha managed to pump biotechs that he was being paid to promote the companies. Talk about a conflict of interest.

Now, the article only goes as far as to point out that these events were a hoax. However, these types of articles published by reputable companies pushes the greed agenda in the market. Of course, I hold people accountable for their own actions, but these types of articles will push some to take on unnecessary risks and go all-in on a trade with the hopes of hitting it big. I know there was one trader out there that said, if this 17-year old can make $72M, well so can I!

In Conclusion

All-in trades will happen to you at one point or another in your trading career. What separates the hobbyist from the professional traders is that professionals do not take all-in trades under any circumstances.

Remember, if you see someone on the web publishing a post that you know pushes the moral boundaries, do your part and leave a comment or report them to the SEC. Trading is a hard enough business; we do not need people out there pushing garbage. These get rich harmless tweets or 1,000 word blog posts can do more damage to a newbie trader than you can imagine.

Good Luck Trading,

Al

 

Photo Credit

Poker Chips – Alan Rampton

Home Run – Mike K

Man in the Mirror – Nimshap

What is Day Trading?

The act of buying and selling securities intra-day with the expectation of making fast profits within minutes to hours is known as day trading. Day traders come in all shapes and forms, using mechanical to systematic day trading systems, and can place anywhere from one to thousands of trades per day.

Types of Day Traders

Breakout Traders:

Many day traders will trade momentum and focus on day trading breakouts above swing highs and swing lows while others will look to trade reversal setups after gaps.

Reversal Traders:

Counter-trend traders will look for signs that a stock is topping or bottoming out before they place a trade in the opposite direction. For example, reversal traders use tools such as the TICK, TICKI, Put Call Ratio, volume, etc. to anticipate a change in trend.

Range Traders:

Range traders find stocks that have been trading within support and resistance levels and buy when a stock hits support and sell when it hits resistance. Range traders will be most successful in markets that are choppy and that have no real direction.

Regardless of the type of trader, the most important aspect of day trading is the discipline to follow a set of rules and establishing your own money management principles which you live by.

Day Trading Risks & Rewards

With the use of margin, many day traders can leverage anywhere from 2 to 4 times the cash balance of their account. While this can become very profitable, it can also lead to major losses, especially for newer traders who have not established their loss management principles. In reality, most of the day traders that enter the game lack the discipline to adhere to strict rules and end up losing large amounts of money. These traders can be classified as gamblers. However, a disciplined day trader can take large sums of money down if they have the appropriate systems and money management in place.

Day trading is an up hill battle for most because day traders do not only have to place a winning trade, they have to first offset the commissions before they can go into a profit position.

Commissions

If you are day trading, commissions will be of utmost important for you to manage. Most full service brokers will charge a flat fee for trades while other brokers, such as Tradestation, charge per share. For smaller traders who are just starting out, per share trading is great for practicing with smaller commission.

For those of you trading with a couple thousands share blocks, a flat commission structure will most likely be more beneficial. The key is finding a broker who will provide a platform which will allow the speed to execute orders and also provide for the ability to decide which commission structure is best suited for your trading style. eSignal seems to partner with a few brokers that allow for this.

Pattern Day Trader Status

The SEC has put a barrier in place to protect investors which requires investors to maintain a minimum balance in their accounts if they plan on making at least 4 round trip day trades in a 5 day period. If you plan on day trading, you will need at least $25,000 in your account on a closing basis to continue day trading.

 

Let’s really take a look at what risk is. Risk is the possibility of loss or injury, something that seems dangerous to us. Risk is uncertain, it is unpredictable. When you define trading risk, you are calculating the probability of a stock going up versus that of it going down. This is very useful because it allows you to weigh how much trading risk you are willing to take against the possibility of a gain in light of the uncertainty. It is essential to be willing to assume trading risk in order to achieve the desired result of profits.

Setting Goals

A great way handle the uncertainty in the markets is to set future oriented goals for yourself and then develop a trading strategy or trading system that will allow you to achieve that result. It is essential that you stay aligned with your goals and trading strategies; by doing this, you help to eliminate some of the uncertainty and establish trade risk management.

What Is An Appropriate Level Of Trading Risk?

It is difficult at times to draw a line between prudent risk and thoughtless risk. This will require considerable practice, preferably through paper trading. Also, you should work at gaining a better understanding of the company you are dealing with by performing fundamental analysis and technical analysis, and finally control your own psychological contribution to the process.

If you are too risk averse, or “trading scared”, you will not have the stomach to hold your winning positions long enough to realize the potential profits that you expect. Conversely, if you are an action junkie and risk too much, you may get into a game of taking huge draw-downs and that can psychologically wear on your brain over the trading day. With concentration, you can learn to tolerate the uncertainty and ride out the uncomfortable feeling that a drawdown presents. After some time, you will begin to trade in the “zone”, a mind set of action, focusing on the here and now, without dwelling on your past mistakes or emotions. This will allow you to take proper levels of risk, balance and size your trading risk, and tolerate the uncertain nature of the trading risk.

Know Who You Are As A Trader

If you can get in touch with your core being, you can then shape your trading without any preconceptions at all. That is the key to success, to be liquid and adjust to different market environments without the ego and the hard hat.

Many traders say that the psychology of risk is the psychology of confidence. Confidence means knowing how to trade in all situations and this comes with practice and patience. If you get that feeling in your gut that you are “gambling”, you are probably not confident. Confidence comes from time-tested consistent gains. Be patient and follow your trading plan and confidence will naturally come. In your core, you know that a week or two of gains doesn’t make you a professional. Be honest with yourself.

Taking trading risks and conquering market uncertainty requires you to be on the cutting edge, learn new skills, and stick to your trading plan even in the face of difficulty. Drop your ego, allow yourself to be coached by others with experience. Do not be afraid to ask questions and don’t feel the need to be in control all the time. The best traders that I have seen are humble, resilient, and always looking to better their trading skills so that they can remain grounded and objective in handling their trading risk.

Additionally, taking risk and eliminating market uncertainty requires a trader to work on not getting distracted, augmentative, or even too opinionated. Be able to get smaller in trade size when your trades are going against you. Don’t allow your ego to play a big role in your trading activities by holding losing positions way longer than you should be, risking disaster. Be liquid and allow yourself to increase your skill set and learn new concepts.

#1 – Trading Plan

I find that you can ask yourself a few questions to keep yourself honest and better understand your trading style. Think of a few recent trades that you made, review the stock chart and ask yourself the following:

  • What price did you enter the trade?
  • Did you add additional shares as the stock went in your favor?
  • Where did you sell out?
  • Can you correlate your trading style to the manner in which you managed the trade?
  • Did you buy shares near the bottom and then add more as the stock went up? Or did you buy and sell quickly once you landed a small profit?
  • What lessons can you learn about your trading style from the way you managed this trade?
  • How would others have traded this stock chart? What do you need to do in order to grow your trading style and the amount of risk you are willing to assume?
  • What is holding you back from doing this?
  • What is a sticking point for you that is preventing you to reach that next level; something that you have trouble with because it creates much anxiety and uncertainty?
  • Do you have trouble buying/shorting more shares even when you are very confident that you are right? This line of questioning should help you understand who you are as a trader and what steps you need to take to improve your trading risk profile.

#2 – Stop Loss Risk Management

The best way to predefine the trading risk you are willing to take is to build a stop loss management plan. First of all, every time you are entering a trade, you need to have a stop loss in order to protect your bankroll. When you are working on your trading strategy, you should identify the percentage of the trade size you are willing to risk. When you find out this percentage, you should do a simple calculation in order to define the level at which your stop loss should be placed.

Let’s say your bankroll is $10,000. In this manner, after the maximum day trading leverage of 1:4, you will have buying power of $40,000. Now let’s say that the maximum trading risk you are willing to take equals 1% of your bankroll. This means that you are ready to risk 10,000 x 0.01 = $100 maximum in each of your trades. But the buying power you are managing is $40,000, right?

Now you need to define how much of your buying power you are willing to invest in each of your trades. Let’s say you want to invest 1/8 of your buying power ($40,000) in each of your trades. This means that you will be putting 40,000 x 1/8 = $5,000 in each of your deals. We will risk $100 (1% of the bank) in each trade with investing $5,000. In order to find out the proper location of your stop loss, you need to define what percentage $100 take from $5,000. We can find this out with a simple calculation:

100 / 5,000 = 2% (0.02)

In this manner, your stop loss should always be at a 2% distance from the entry price. This way you will always risk $100, which is 1% of your bankroll. Let’s have a look at the image below.

Stop Loss Orders
Stop Loss Orders

This is the 15-minute char of Electronic Arts for Jan 15 – 25, 2016. The image shows two long entries with their respective stop loss orders.

In the first case, we enter into a long trade with EA at $65.85 per share. In order to keep our 2% (1% Bankroll Risk) rule, we need to position our stop loss order $1.32 below the entry price. Let me show you the calculation:

$65.85 x $0.02 = 1.32

This means that our stop loss should be located at $65.85 – $1.32 = $64.53 per share.

In the second case we enter into a long trade with EA at $68.04 per share. We keep our 2% (1% Bankroll Risk) rule and we place the stop loss $1.36 below the entry price. Let’s do the math:

$68.04 x $0.02 = $1.36

Therefore, our stop loss should be located at $68.04 – $1.36 = $66.68 per share.

This way the two stop loss orders will cover a maximum loss equal to 2% of the amount we invest and 1% of our bankroll – $100 loss.

$100 is 1% of our $10,000 bankroll and 2% of the $5,000 we invest in each of our trades.

#3 – Return-to-Risk Ratio (Win-Loss)

In every trade you undertake you should have clearly stated goals. This means, you should always know how much you are ready to lose and what you are aiming for in terms of profit target. But how do you do that? Easy! The same way as with stop loss management. However, this time you manage your target.

In the example above, I showed you how to risk only 1% of your bankroll, which equals 2% of the amount you invest.

The same is in force with your target. If you aim for profit equal to 1% of your bankroll, you should catch a 2% increase if we take into consideration the rules from above. This way you will risk 1% of your bankroll (2% of the trade) and you will aim for 1% profit (2% increase). In this case you have 1:1 Return-to-Risk ratio, because you risk 1 to get 1.

1:1 is the minimum you should aim for if you implement high frequency trading and you open more than one trade per day. In other words, do not risk more than you aim for if you are a day trader.

However, there is an exception. If you implement a high probability strategy, where the success rate is more than 65-70%, then you can put a loose stop loss. The reason for this is that the stop will only be meant to protect you from rapid price moves against your trade. The loose stop loss could also be used when you leave your trades overnight (which I do not advocate).

Sometimes, when you want to trade a big gap, you can loosen your stop loss in order to cope with extremely high volatility during the opening bell.

Let’s now cover various risk to reward ratios when day trading.

  • 5 : 1 Return-to-Risk Ratio

The image below will show you where your stops and targets should be if you want to attain 1:2 win-loss ratio.

Return to Risk Ratio
Return to Risk Ratio

Above you see the 2-minute chart of Twitter for Dec 23, 2015. The image illustrates a trading situation, which provides 1.5:1 Win-Loss ratio.

We have a classic double bottom chart pattern in the image above. When the TWTR price breaks the trigger line of the pattern, we get a long signal. A stop loss should be placed below the last bottom of the pattern. Also, according to the double bottom rules, the potential of the pattern is the price to reach at least a bullish range equal to the size of the formation.

So, the stop loss should be located below the bottom $0.06 (6 cents) below the entry price, which is 0.28% risk. At the same time, the minimum target we pursue should equal the size of the formation. This is $0.09 (9 cents) above the entry price, which is a 0.42% target.

0.42 / 0.28   :    0.28 / 0.28

equals to 1.5 : 1 return-to-risk ratio.

  • 2 : 1 Return-to-Risk Ratio

This time I will show you an example where the win-loss ratio is 2:1. Have a look at the following example:

2 to 1 Return to Risk Ratio
2 to 1 Return to Risk Ratio

Now, we look at the 2-minute chart of Netflix from Aug 21, 2015. The image illustrates a bullish harami candlestick pattern, which we enter a long position with a 2:1 win-loss ratio.

In the green ellipse you see the bullish harami pattern which comes after a bearish trend. The candle which comes after the pattern is the trigger candle.

Therefore, we go long with the closing of the trigger candle as shown in the image above. The stop loss should be placed right below the candle pattern’s low point. This is $0.94 (94 cents) below the entry price, which equals 0.90%. We pursue 2:1 return-to-risk ratio. So, let’s calculate.

In order to get a 2:1 win-loss ratio, we need to double the amount we risk:

0.90% x 2 = 1.80% (target)

So, our actual win-loss ratio is 1.80% : 0.90%. Let’s check:

1.80% / 0.90 : 0.90% / 0.90 = 2 : 1 Return-to-Risk ratio

Of course, 1.5 : 1 and 2 : 1 are not the only options for win-loss ratio you should approach. They could vary the way you want. You should approach your own trading strategy with a certain return-to-risk ratio, which will satisfy your trading behavior. In this manner, there are win-loss ratios like 3:1, 4:1, 5:1, or whatever you want. Just remember something: The higher the win-loss ratio, the less the success rate of your strategy is likely to be. After all, if you pursue a 7:1 risk-to-return ratio with your strategy, if you have 70% success rate, you have essentially developed a winning strategy.

Just to clarify something on the stop loss, you do not have to allow your order to be triggered.  If I am looking for a specific gain of let’s say 2% and the stock begins to fail, I will use time and sales to judge if I should exit a trade.

This way over time, your win ratio will continue to increase which, will increase your per average trade profit.  It will also place you in a winner’s mindset as you get in a constant rhythm of pulling money out of the market.

#4 – Trailing Stop Loss Order (TSLO)

Profits will run in your favor to a point and then all of a sudden, things can go against you quickly.

If you are in a trade and the price moves in your favor, there is nothing wrong with adjusting your stop. This way you can lock in guaranteed profits.

The trailing stop is a regular on-chart market order, which gets you out of the trade, when specific requirements are met. As you probably guess, the name “trailing stop” is related with the character of the order. The trailing stop simply trails behind the price action, when the stock is trending in your direction. However, if the stock is moving against you, the trailing stop does not move.

Let’s say you buy Oracle at $35.00 per share and you place a trailing stop $0.35 (35 cents) below your entry price. This means that your trailing stop will get you out of the market at $34.65 if the price decreases immediately.

However, if ORCL enters a bullish trend and the price increases to $36.00 per share, then the trailing stop will be automatically adjusted at $35.65 per share. Since we entered at $35.00, we will have a locked-in profit of $0.65 (65 cents).

If after reaching $36.00 per share, the price begins to drop, the trailing stop holds at $35.65.  Conversely, if the price begins to rise above $36, the trailing stop loss will move higher accordingly.

A key item to remember when placing trailing stops is to account of the volatility of the underlying security.  Meaning if a stock has 3% moves per candle, a .5% trailing stop will be triggered.

Conclusion

  • You should always have set goals when you implement your trading strategy. Ask yourself: What is my target and what loss am I ready to take to reach it?
  • Examine your trading psychology. Are you too tight when you trade? Or maybe you are too aggressive in your trading? The answers to these questions might help when you develop your trade risk management rules.
  • Trading is all about planning. Therefore, you should have your own trading plan. Create a list of questions, which you ask yourself in every trade. Take into consideration entry price and eventual outcomes.
  • Always use a stop loss order when you buy or sell a stock. This way you will never lose more then you planned.
  • If your trades give you a high success rate, pursue a lower win-loss ratio. If your trading strategy gives you a low success rate, but with high returns, stay tight and aim for the highest risk-to-return ratio.
  • The trailing stop loss order is an ultimate way to implement trade risk management. Decide on the size of corrections you expect and use it to set the parameter of the TSLO. This way the stop will follow the price action, locking-in profit on the way up. At the same time, you will handle the corrective moves.

Taking Profits – Definition

When you start out in the trading game, you often will hear a number of pearls of wisdom. Keep your losses small, let your winners run, no one ever went broke taking profits. These anecdotes make trading sound so easy. One of the biggest reasons for so many losing traders on Wall Street is the fact they take profits too early. If you continuously take profits before you let your harvest come in, you will go broke.

Example of taking profits

First off trading is a game of odds. Anyone that tells you otherwise is either delusional or not a seasoned veteran. Since it is a game of odds, much like a casino, the only way to win is to have your winners be bigger than your losers and to have more winners. This sounds simple enough, but remember when you are wrong, you are not only in a losing trade, but you also have to pay commission. For day traders, this fact is all to critical to your bottom-line as you are looking for relatively small price fluctuations to make a profit. So, how do people go broke taking profits? Let’s say Trader A purchases 200 shares of MSFT at $50 and pays 4 dollars in commission. The stock runs up to $50.25 and Trader A sells for a quick half of a percent gain. This sounds easy enough right? Well Trader A then puts on a short of 1000 ATVI at $10, but the stock quickly rallies and Trader A has to cover for a half of a percent loss. Trader A invests 10k on all of his transactions, but since the ATVI trade commissions are $16 dollars due to the 1,000 share lot. So, while the percentage gain/loss for the MSFT and ATVI trades are exact, Trader A will actually be down $12 bucks on these trades due to the commission costs.

Grinding Cycle

I know this all sounds really simplified, but what ends up happening over a 1-month period, is that you will end up grinding it out and not having any breakthroughs in your trading profits. This grinding cycle leads to stress and poor trading habits. You as a trader have to determine some method or means of allowing yourself to stay in winning trades, while limiting your risk. Trader A in the above example sold out the minute a half of a percent target was hit, but what if the stock was preparing for a move to $52, or $55? The answer to this question is that you don’t know. But what you do know is that trading is a numbers game much like the casino, so if you structure your strategy to allow you to eat the big winners (whatever a big winner means to you), you will be able to achieve much greater success than to constantly sell a stock for the simple fact you have made a profit. If you get one thing out of this article, you must remember that you only sell a stock when you have a predetermined reason for doing so. Never sell a stock just to take profits, remember your security could end up going much higher.

Take Profit Money Management

Before entering any trade, you should have your profit target in mind.  You simply cannot stay in a trade forever, especially as a day trader.

In this portion of the article, we are going to explore a number of profit taking strategies based on market conditions.

Trend Lines – Profit Taking Strategy

A traders dream is to catch a stock as it is trending.  Trending price movement allows you to effectively reap solid returns, without much headache of volatility.

For trending stocks, there are really two ways to trade the setup.  The first is to open a position in the direction of the primary trend and sell when the price breaks the primary pattern.

The other option is to enter a trade when the price bounces back in the direction of the primary trend and exit once the stock begins a counter move. This buying and selling approach allows us to maximize the profit potential of a trending stock as you capture the minor moves within the larger trend.

So, how exactly do we place the trades?

Taking profit when the price breaks the trend:

Again, one strategy for when to take profits is to identify a trending stock and hold your position until the primary trend is broken.

Hold Strategy
Hold Strategy

This is the 5-minute chart of Wal-Mart Stores for the period June 29-30, 2015. The black bearish line shows the resistance level of the downtrend. As you see, the trend starts on June 29; however, the market was closing in an hour, so we do not open the short position. The next day, Wal-Mart rolls over after a bullish gap up, thus reconfirming the strong downtrend.

At this point, we open a short position and hold Wal-Mart until the stock is able to close above the black line, which is almost three hours later with a profit of 48 cents per share.

Taking profit at the end of each move in the direction of the primary trend:

I know what you are thinking, “I can make more money because I am trading all of the minor moves within the larger trend.”  Well, yes and no. The reality is that placing more trades does not always equal more profit.  Remember, every time you place a trade, you are risking your capital.

Back to the trading strategy, you essentially allow the stock to hit the resistance or support of the primary trend and then open a position in that direction.  So for example, in our previous Wal-Mart trade, you would short Wal-Mart every time the stock approaches the black line and then exit that short once the momentum in the stock began to taper off.

Trade Minor Moves
Trade Minor Moves

Above is the same Wal-Mart stock from the period June 29-30, 2015; the one difference is the chart time frame.  For this example, we are illustrating the 1-minute chart in order to better identify price action as Wal-Mart interacts with the black line.

As you see, the downtrend is divided into 7 different trending moves, which all present trading opportunities. For this trading example, we will short Wal-Mart every time it fails at the black line and then exit our short once we see a counter trend candlestick pattern develop.

First 5 Trades
First 5 Trades

The above chart illustrates 5 trading opportunities for this one move in WMT.  Below I have provided the rationale and details for each trade:

  1. In the first circle, we receive our trend confirmation. The price touches the trend line and develops a doji candle. At this point, we short Wal-Mart and just 4 candles later two doji candlesticks print in a row. Since the doji candle has a strong reversal characteristic, we exit the trade.Profit: $0.12 per share
  2. The price then has a counter move back to the black line and once again prints a doji candlestick at resistance. We know what to do here, right? We short WMT. The price starts another bearish trending move. We take profits the moment we see a candle closing above the previous one.Profit: $0.05 per share
  3. Then we see a slight consolidation around the resistance line. We short WMT with the first bearish candle on the trend, because this is considered a bounce from the trend. Again, our signal to take profits occurs when the candlestick closes above the previous bar.Profit: $0.06 per share
  4. For our next trade, the price suddenly displays an inverted hammer candlestick pattern at the trend line. The inverted hammer has a reversal characteristic, which means that it is the perfect short signal in our case and we open a position. We take profits when the price closes above the small bearish trend (blue line).Profit: $0.16 per share
  5. Since we are out of the market now, we need another price interaction with the bearish trend in order to enter the market. This happens 15 minutes later when price touches the trend line and prints a bearish candle. This is a bounce from the trend line and we short WMT again. The price starts consolidating afterwards. Notice that there are more than two bullish candles in a row here. Nevertheless, we stay in the trade since these candles are on the trend line and there is no point in closing the trade early. Suddenly, WMT decreases sharply and after two red candle bars, we spot a Hammer candlestick and we exit the trade.
  • Profit: $0.05 per share

Let’s now switch to trades 6 and 7:

Trades 6 and 7
Trades 6 and 7

6. After a short hesitation below and above the bearish trend, price switches again below the trend. We short WMT with the first bearish candle, which closes below the trend line. A few candles after we enter the market, we spot a falling wedge chart pattern. The price closes a candle outside the wedge, which is our signal to take profits. Profit: $0.10 per share

7. The next interaction with the bearish trend comes 13 minutes later. We short WMT with the first bearish candle after the price touches the trend. A decrease appears afterwards. Notice the first red circle of trade 7 (second red circle on the chart); two bullish candlesticks develop in a row. Nevertheless, we stay with the trade since there is resistance at the blue line. Sure enough, this patience pays off and the stock breaks down. The last red circle in the chart displays when another cluster of consolidation candlesticks form and we exit the trade based on this development. Profit: $0.27 per share

The total outcome from this profit taking strategy is $0.81 (81 cents) per share.

Which Profit Taking Strategy is best for Active Trading?

The results are clear; trading the minor moves, we made a total of $0.81 per share, which is nearly 70% better than the holding, the stock until the equity breaks the primary trend.

Again, trading minor moves within a trend requires years of practice and with the increased number of trades, you only need one to go wrong to give back these additional profits.

Channels – Profit Taking Strategy

We will now shift gears to discuss a profit taking strategy using price channels.

Both strategies have the same entry point system – buy the equity when the price bounces from the lower level of the channel; however, the exit strategies are slightly different.

The first strategy suggests exiting a position once price touches the upper channel.

The second strategy calls for you to exit a position after price touches the upper channel and produces two bearish candlesticks.  Why the two extra candles?  There is a possibility that the stock could breakout above the channel and this would allow us the opportunity to capture additional gains from an impulsive move higher.

Let’s look at a real-world example to see which system fares better.

Take profits when the price hits the upper channel level

This is probably the most common and at the same time effective channel profit taking system. One should hold his trade in the channel until the price touches the upper level.

Trend Channels and Profit Targets
Trend Channels and Profit Targets

This is the 2-minute chart of Blackberry from July 24, 2015. As you see, the blue lines on the chart indicate a clear bullish channel with four long positions inside. Let’s measure the results of this profit taking strategy:

  • 4 long positions
  • 3 successful; 1 fail
  • Profits:
  • $0.06 per share
  • $0.09 per share
  • $0.11 per share
  • -$0.01 per share (loss)
  • Total Profit: $0.25 per share

Taking profits after touching the upper channel level + two bearish candles

We applied this strategy on the same chart in order to see the difference. Notice that the exit signals are different from the previous image.

Trend Channels and Profit Targets - 2
Trend Channels and Profit Targets – 2

The only time the price breaks the upper level of the channel is during the first trade. However, the bullish break is unsuccessful and the price quickly retreats into the channel. Let’s check out the results of this trading strategy:

  • 4 long positions
  • 3 successful; 1 fail
  • Profits:
  • $0.04 per share
  • $0.07 per share
  • $0.8 per share
  • -$0.01 per share (loss)
  • Total Profit: $0.18 per share

As you see, in this case we generated ~28% less profit than the previous trading system.

This is an off-beat trading strategy. It is very efficient for unpredictable and highly volatile stocks, which tend to increase or decrease exponentially. However, in our Blackberry example above, there was only one break above the upper channel, which lasted all of two minutes.

Automated Profit Taking

Most of the platforms for equity trading offer automatic profit taking capabilities.

Trailing Stop Loss Order

The trailing stop loss order is another market execution feature. It performs the same function as a regular stop loss, because it closes the position when the price hits a certain level. However, the trailing stop is placed a fixed distance from the current price and trails the price action. Therefore, as the price moves in your favor, the trailing stop allows you to gain more profits.

Conclusion

No one ever went broke taking profits out of the market.  As you learn more about yourself and what makes you tick, remember that profit targets are essential to becoming a successful trader.  This fact becomes increasingly important when day trading, as the profit taking windows are often short-lived.