Friday, March 8, 2013

How to Trade Using Risk-Reward-Ratio

The market has a mind of its own. Which direction will it take in the future is unknown. Unknown not only to you, not only to me, but also to the best of analysts and astrologers. Yet you see the market full of such people who are trying to predict the markets, including yours truly. The reason why they are doing it is because it works, it actually works. But if you expect that you will get a positive result 100% of the times, then that is the biggest mistake you will be making. Technical Analysis, or for that matter, any technique, works most of the time but never 100% of the time. And that is the first and foremost thing that you and I need to understand.

Once we are clear about this, we know that we will profits and we will make losses as well. If we make more losses than profits then trading is going to wipe us out. So, what we need to do is make more profits than losses. And once we are making more profits than losses, and if we know that losses are inevitable, we will not be scared of it. And that is what we are going to learn in this post, i.e. how to get stocks to make us money?

Before we go any further, let us first start with probability. Whenever we enter into a trade using any method/technique, or even without using any method, there can only be two consequences - either we are going to end up with a profit in that trade or we will end it in a loss. So, the probability of making a profit in that trade is 1/2 (i.e. having one positive outcome out of two possible outcomes) or 50%. That is, even if any random investor, gets into a trade with his eyes, ears or all his senses closed, he still has a 50% chance that he will end the trade in a profit. Now just imagine, if we were to attach any kind of analysis technique to our trading, wouldn't we be able to increase that probability to about 70%? Obviously, we would and this is where I remember my mentor's words which are still very crystal clear to me, and that is, that Technical Analysis is nothing but improving the "probability of profitability".

And while we are talking about your success in Technical Analysis, success depends only on two things - your accuracy and your risk-reward-ratio. While you may think that accuracy is most important, actually it is not. Risk-Reward-Ratio is what measures your success. And by risk-reward ratio, I mean that when you generate trading ideas, how far are the target and stop loss from the entry price. A person may have an accuracy of 40% and he may still be making more money than a person having an accuracy of 90%. Let us take a specific example. "A" has an accuracy of 90% and a risk-reward ratio of 1:1, i.e. Re.1/- stop loss for a target expectation of Re.1/-. He makes 100 trades in a month out of which he ends up in a profit in 90 trades and a loss in 10. He makes a profit of Rs.90/- (90 x 1) from the profitable trades and a loss of Rs.10/- (10 x 1) from the loss making trades, thus making a net profit of Rs.80/- for the month. Another analyst, "B" has an accuracy of 40% and a risk-reward-ratio of 1:4, meaning that he expects a target of Rs.4/- for every rupee of risk that he is taking. If he also makes 100 trades in a month, he will get 40 right and 60 of them would be unfavourable. In the 40 profitable trades, he will make a profit of Rs.160/- (40 x 4)  and a loss of Rs.60/- (60 x 1) in the loss making trades, thus making a net profit of Rs.100/-. My mentor is hugely successful and (in his own words) he only has a hit percentage (or accuracy) of 30-40%.

I myself have noticed that I have an accuracy of around 55-60% and in most cases, I follow a risk-reward-ratio of 1:2 (i.e. if my stop loss is Rs.10/-, I would take the trade only if I have a reasonable certainty in my mind that I can achieve a target of at least Rs.20/- in that). I have also seen that in a market where there are innumerable stocks that move in excess of 2, 3 or 4% in a particular day, even if we have a pretty decent expectation of 0.5% in each trade, we should be able to find innumerable trades. But, at the same time, the number would reduce considerably, if also one of our conditions is that we should not be exceeding a stop loss of 0.25% in each trade. Let's say, we find only 5 such opportunities during the day. Considering that we trade about 20 days in a month, we do about 100 (5 x 20) trades in all, 60 of which (60%) are profitable and 40 trades (40%) wrong. We gain 30% in those 60 trades (0.5 x 60) and lose 10% (0.25 x 40) in the loss making ones. Still a net return of 20% per month. Even if we assume that we take all those 5 trades simultaneously (though, that will rarely be the case), we would need 5 times capital, which means that we get an effective return of only 4% (20/5) per month. Even than "only" 4% per month converts into "only" 48% in a year. Tell me any other opportunity today, which is giving you almost 50% returns in a year.

But yes, to find such trading opportunities during the day, you would need to know technical analysis. If you still don't know Technical Analysis, do a course in Technical Analysis from an experienced analyst. If you need help finding the right place for you to do a course, please send in your queries to vikas@sharma.es and I will be more than happy to answer them.

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Happy trading!!!