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Risk / Reward

Discussion in 'Strategy Development' started by malaka56, Jan 27, 2006.

1. malaka56

After the stop loss determination thread, I thought it might be nice to have a Risk / Reward thread, especially since I being an aspiring systems trader am not completely clear on the subject.

I would imagine that R/R would be determined by your system, and the average win versus average loss - which is of course theoretically known by thorough backtesting and included in expectancy calculations. But the way people talk about R/R makes it sound like it is a variable ratio, and I could only see how it would vary from your backtested model (real world performance differences excluded, slippage, etc) if the setups you trade on vary, or if your entry to the setup varies. People talking about only taking appropriate R/R trades must trade multiple setups, or be discretionary traders, right?
How you do determine R/R and use it in your strategy?

I have seen some people refer to rise/run type risk/reward, as well...

2. horribilicus

Some trades have a fixed, known-in-advance, maximum possible profit AND a maximum possible loss. Buying a vertical option spread is one example: Buy the OEX 900 call for 2.00 and at the same time sell the OEX 905 call for 0.50. Max possible loss (if OEX closes below 900) is 1.50 and max possible gain (if OEX closes above 905) is 3.50. Thus reward/risk = 3.5/1.5 = 2.333

Some TRADERS choose to disregard the old saying "cut your losses but let your winners run". They religiously buy IBM stock with a stoploss of 0.5 point below entry and a profit exit of 1.0 point above entry. They'll exit the position on a limit order, 1.0 point above their entry price: Take the profit of 1.0 points and get the hell out! Their maximum possible loss (ignoring gaps!) is 0.5 point and their maximum possible gain (ignoring gaps!) is 1.0 point. Thus reward/risk = 1.0/0.5 = 2.000

3. coolweb

R/R is depended on the opportunity

Just fyi..

4. tireg

To determine risk (disregarding slippage/commissions):

Risk per unit = [target] entry price - stop price. If you get stopped out, you will lose this much per unit.

Multiply above by # of shares/contracts/whatever you're trading to get total amount risked. This is the most amount of money you will lose in the trade if you get stopped out. For many people, and most professionals, this number will be under 2% of your total capital.

Risk % of the trade = Risk per unit / [target] Entry price.

Example: Target entry at 10.00 with stop of 9.00, Risk per unit = 1.00; if you buy 10 shares your total risk will be 1.00 * 10 or 10.00. Your risk % will be 1/10 or 10%.

To determine reward:
Reward per unit = [Target] Exit price - [Target] Entry price.

Multiply the above by # of shares/contracts traded to get the total amount of reward.

Reward % of the trade = Reward per unit / [target] Entry price.

Using the example above, If you enter at 10.00 and your target is 12.00, your reward per unit will be 2.00 and your reward % will be 2.00/10.00 or 20%.

Thus, you have a 10:20 risk/reward ratio.

You can use these principles to calculate future trades you are about to take, using target numbers, or you can use it to calculate historical trades and get historical figures.

5. malaka56

Ok, well i always calculate risk, and i use usually 1.5% capital risk per trade, but I usually don't calculate the reward. i should do this. but again, i guess it is impossible to calculate reward without a thorough backtest of your system and statistically significant data which can show you the mean, median, mode of your "reward" on your winning trades. As of now, i generally calculate risk, position size accordingly, but using trailing stops as my lame exit strategy as i have no pre-defined reward i am expecting. Thanks for the info.