How professionals manage risk

Ahh … risk reward … a hotly debated topic among traders.

Most have an opinion on the best risk reward ratios …

… along with thoughts on what’s wrong with other trader’s ideas on the subject.

But, if you’re scratching your head and wondering what all the fuss is about, here’s a quick 101 on what risk-reward ratios are …

Risk is how much you would expect to lose if your trade is unsuccessful; reward is how much you expect to gain if your trade is successful. So, a risk-reward ratio is one of these numbers set against the other.

If you’re risking £1 to make £2, then your risk-reward ratio is 2:1. That’s £2 profit for every £1 loss.

If you’re risking £50 to make £150, then your risk-reward ratio is 3:1.

To be profitable, your risk-reward ratio needs to be balanced against how many trades you actually win, and how many you lose. (You can find more background on risk-reward here.)

Over-simplifying the Risk Reward Ratio

The simplistic way to look at risk-reward is to think that risk is bad … reward is good … therefore an RRR with a big reward and a small risk is what we want. We can think of the risk as a “payment” for our potential reward. The idea of paying as little as possible is attractive – we all love a bargain!

But, as any shopper or consumer knows … if you buy cheap, you’re unlikely to get quality.

So, to follow that analogy through, if we take a small risk (i.e. we pay cheap), what does that say about the rewards we can expect?

Just as what you pay affects what you get … so, risk and reward are inextricably linked.

What is risk?

Risk is all about the unpredictable. If we toss a coin, you could get heads, you could get tails. The only way to remove that uncertainty is to not toss the coin at all.

Likewise, if we enter the market, we could win, we could lose. If you want a risk-free solution, then trading isn’t for you.

It’s the same unpredictability that could bring you untold riches or unwanted losses. That unpredictability is as much our friend as it is our enemy.

So, risk and reward can’t be put into separate boxes … despite what much trading advice will tell you.

The received wisdom

Did I mention before that I’m not a fan of the ‘received wisdom’ on risk-reward ratios?

There’s a lot of ‘helpful’ advice out there for traders about using a risk-reward ratio of at least 2:1 (i.e. your rewards must be at least double your risk). This is touted as the worst-case-scenario trade you’d be entering, while you should ideally be hunting down 3:1 … 4:1 … offerings.

It sounds great doesn’t it? Only take a tiny risk, for a large potential reward?

But, as we’ve seen, risk is tied up to reward.

We can’t just enter a trade, and set up parameters for a high reward, low risk … and expect it to come good.

I know that many of us were first lured into the trading game by the idea of scalping profits. These are strategies in which we risk just a few pounds with a super-tight stop loss, hoping to make much bigger profits with a wider profit target. You might be trading with a 4-point stop, and a stake of £2; combined with a profit target of 10 points. We tell ourselves that we can’t lose! Even if we only get it right 50% of the time, we’ll soon be rich!

But tight stops and wide profit targets are not the silver bullet to profitability. And anyone who’s tried these kinds of systems will tend to find their stops hit a lot more than 50% of the time (while paying their broker a hefty share of every trade in spread charges!)

At the other end of the extreme, if your stop distance is wide enough, you’ll never get stopped out!

In fact, tests have shown that trading without a stop loss at all will, ultimately, be more profitable than trading with one. However, you’d need unfeasibly deep pockets and plenty of patience to trade this way (I don’t recommend it!)

No matter where you put a stop, it will hurt performance. And the tighter that stop, the more it’ll hurt.

Based on that knowledge, the ultimate, can’t-lose trading strategy would look like this …

• unlimited funds
• no stop level
• take profits as soon as possible

Yes, that really is as infallible as you can get for a trading system.

There’s an obvious problem, of course … because I expect that you, like me, aren’t able to access unlimited funds to get through the rough patches!

But if you look at this as the ‘ideal’ it’s hard to see how we’ve ended up with so many traders preaching about 2:1 risk-reward ratios.

So, now let’s look at what a professional risk manager advises we do …

Martin Carter, the creator of Diff Code Global and former risk manager, sets his stop distances at 2x his profit target.

This gives him an initial RRR of 1:2. The exact flip-side of what many ‘trading gurus’ tell you you should be doing.

You’ll notice that I say ‘initial RRR’ – because by the time his trades are closed, which sometimes is signaled before a stop or target is hit, this ratio is significantly tightened, with risk being closer to 1.5x reward. But, even then, it’s a long way from the ‘received wisdom’.

The reason this works (and it does – phenomenally well) is because these aren’t stops that are designed to be hit. They are designed to be well out of the way, so that around 70% of trades will be winners.

And, of course, Martin’s Diff Code methods have extra security built into them, with his use of hedged markets.

So, what’s the RIGHT RRR?

The trick with Risk-reward ratios is to look objectively at them. Have they been arbitrarily set to look good and match expectations?

Or are they about seriously managing risk, and maximizing rewards?

And, even more importantly, do they work?

To enjoy more content and get it faster Follow @TradersBulletin

Save

Save