I wasnt going to carry it any further but I think I see where we are bumping heads. My statement about 20% winners was in your reply to only hitting your target 20% of the time. If you are only hitting your target 20% of the time, then your analysis is flawed. I stand by that. I did not mean that a system with a small percentage of winners could not make money. If your system has an 80% reliability then risk is small. You can risk $75 to make $25 and make money over the long run. It still has a "favorable" risk/reward ratio. Which number is bigger or smaller has nothing to do with it. Have a nice day.
Nic, Thanks for clarifying things a bit more. I see part of this was definitely just an issue of language. It still has a "favorable" risk/reward ratio. Which number is bigger or smaller has nothing to do with it. As it's generally understood a favorable reward/risk ratio does mean a higher number such as 2:1, 3:1, or even 4:1. For instance, Tony Oz won't put on a trade unless the R/R is at least 3:1. So favorable has nothing to do with whether the trade turns out to be a winner or a loser, just a higher ratio between the (hopefully reasonable) target and the (again, hopefully reasonable) stop. Anyway, you also have a good day.
. How do you calculate risk/reward? There are actually two calculations. The ratio you are referring to is the money ratio and is only half the equation. There is the money ratio and there is the risk ratio and there is the relationship between the two which is the actual risk/reward ratio. In the example I used of the 80% system, the risk side would be 2/8 and the money side would be 75/25 or 3/1 and the ratio between the two would be 3:4, risk:money which is the actual risk/reward ratio and it would be a "favorable" one in this case.
Nic, How do you calculate risk/reward? It is my understanding, and in everything I've ever read, that it's a simple mathematical ratio between potential reward (the difference between your entry price and your target price), and the potential loss (the difference between your entry price and your stop price). It's usually designated as reward/risk, not the other way around. The trick, of course, is setting reasonable target and stop prices so that you don't gimmick up the number to get it to an acceptable level. And how you set those depends on your personal strategy whether it's simple numbers unrelated to the chart (i.e., I'll risk .25 to make .50, which gives me a 2:1 reward/risk ratio), or whether you base your target on what you perceive to be reasonable resistance and your stop on what you perceive to be reasonable support. To use round numbers, if your expected fill is 100.00 (ah, the good ole days...) and you see clearly defined resistance at 102.00 (say, yesterdays high), and clearly defined support at 99.25 (say, the previous few days low), then you have potential gain of about 2 pts, and potential loss of about .75. In that case your R/R would be 2 divided by .75 = 2.7, or your ratio would be 2.7:1 For many people (including myself) that would be a very favorable reward/risk ratio; for Tony Oz who requires at least 3:1 it wouldn't and he'd pass on that trade. Now whether the trade turns out to be successful or not, that's a whole 'nother matter
Nic can I add something?? Maybe a trader only hits his winning trades 20% of the time but when he ends of being right he makes 30 times what he risked?? The above system sounds like a position trading breakout system during periods of trending markets. Lots of false breakouts but when a trader is right hold on as you ring the cash register. The above system wouldn't have flawed analysis. It's more of a homerun system than a system of hitting constant singles. does that help guys?? rtharp
This is your monetary risk, not your actual risk. The only way to know your actual risk is to have some idea of how many times, in this situation, you can expect to hit your target and how many times you'll hit your stop. For example, you short a top with a stop .10 above the high and support .40 below. 4:1. But is it an uptrending market, a downtrending market, a sideways market? There is a big difference in risk while the money ratio stays the same. You have to take both into account to arrive at a true risk/reward. I use risk/reward in that order because I always consider risk first. A personal idiosycrasy I'm enjoying the conversatin
Yes different systems work in different markets. It is one of the reasons my father won't get into entry much as whatever works today won't work tomorrow. (yet that is what every trader is doing) Breakout's were great till the end of 99. I had some incredible years buying stocks near 52 week high's and letting them run. Needless to say they don't do so well anymore overall. Breakdowns' than became great but a lot of stocks lately haven't had bases just lots of selling , more selling and more selling. That there is my currently strategy of overbought/ oversold in the extremes which works great for me now. Eventually enough traders will start this and the strategy won't be as great as it used to be. That's when I start another strategy that is working and move on. Constantly reevaluate your system and determine if it fits for the environment rtharp
Nic, To continue the conversation... I use risk/reward in that order because I always consider risk first. A personal idiosycrasy Interesting, because I always say it in the order you prefer, but I write it with reward first because that's the way I always see the numbers done. For example, you short a top with a stop .10 above the high and support .40 below. 4:1. But is it an uptrending market, a downtrending market, a sideways market? There is a big difference in risk while the money ratio stays the same. Not to me, because I take the market's direction into account when I estimate my target and set my stop. In other words, the market's health, trend, etc. play a big part in where I feel there are realistic targets/stops. So the latter aren't carved in stone, solely based on the fill price, but of necessity take other factors into account. You have to take both into account to arrive at a true risk/reward. I agree, and the reward/risk (heh heh) ratio I come up with, to see if the trade is worthwhile to me, most definitely incorporates the market's condition at that moment.
rtharp I forgot to put Magna's name on the post prior to your last one. Thats who it was addressed to. I just finished your father's book. Quite interesting. I am especially interested in random entry. A reference here to that is what made me buy the book. The fact that a random entry system can make money makes it all the more amazing that so many traders wash out. Magna Thanks for the input.
If you are using random entry system you can only expect to match the performance of the market you are trading minus commissions minus spread. More often you trade in such manner less likely you will be to win. Even though I keep hearing all the time that it is more important to know how to exit a trade I still beleive that being able to enter the position with positive expectancy is the cornerstone of profitable strategy. In profitable strategy there is no OR operator. Only AND. Entry AND Exit not Entry OR Exit