Reward to Risk Explained – Pt3
In part two of the Reward to Risk series I demonstrated how to calculate your risk multiple. Now in the final part of the series I want to demonstrate how you’re winning percentage and your reward to risk multiple works as a team to help you reach your trading goals. Okay, I want to warn you, we’ve now reached the math component of the lesson, so you’re going to see a lot of numbers. It’s all very logical and believe me it will be worth it.
First, let’s look at a 50 percent winning percentage. In this example, we keep the 3.15 reward to risk multiple that we learned earlier and if we had an average loss of $1,000.00, this would mean we make $3,150.00 for our reward. If we win 50 percent of the time, that’s $15,750.00. The 5 trades we lose, would total $5,000.00 for a net result of positive $10,750.00. Let’s take a look at the relationship of the winning percentage as it decreases. With a 40 percent winning percentage, you can see with the same reward to this multiple, you’re still going to make a very profitable result with $6,600.00 net.
If we go down to a 30 percent winning percentage, you’re still profitable with $2,450.00 net.
I’ve often said if you can win at least 30 percent of the time and keep a 3:1 ratio in your favor, you’re still going to make money in the markets. Here you can clearly see the importance of keeping your winning percentages as high as possible and maintaining your reward to risk multiple.
In the next series of slides we’ll take a look at a decreased reward to risk multiple. Remember we discussed if you actually calculate your average win and your reward doesn’t make it to the 3:1 that you intend, you’re fooling yourself. Here we have a multiple of 1.55 and with a 50 percent winning percentage, you’re still coming out ahead at $2,750.00, but it’s nowhere near the over $10,000.00 that you had before with the larger reward multiple. The results with a small change in reward multiple makes a huge difference in the results.
If we decrease to a 40 percent win percentage using the same multiple, we’re practically break even. Previously, you still had a great gain of over $6,000.00, but by decreasing our actual reward in half and maintaining a 40 percent win percentage you’re basically winning some and losing some and not really making any money. This is very common and also know as “spinning your wheels”.
If you recall on the previous slides, you actually made money with a 30 percent winning percentage. Here, with a 30 percent winning percentage, you’re losing a lot of money. Even though you’re making more than you lose, you’re losing way too often and your reward to risk multiple is way too low. This is the area a lot of intermediate traders find themselves in. They lose more often than they win, and they don’t make nearly enough when they do win.
Let’s look at an example. Here we can see an entry price of $17.23. I use this as an end of day trade, so I’m using end of day results. The entry price is $0.05 cents above the previous high on the following day. The stop loss price is $0.05 below the entry day’s bar at $16.55. That’s a total of $0.68 risk. The projected target is based on previous resistance; I see $19.00 as a projected target. $17.23 minus $$19.00 has a potential gain of $1.77. $1.77 divided by $00.68 gives you a risk multiple of 2.6.
Now you need to ask yourself a question of, “Does this trade make sense?” Do you take this trade according to your trading plan? Remember, you can’t manipulate the numbers in order to fit them into your trading plan. You know the numbers ahead of time. If these numbers don’t make sense to your plan, then you would have to pass on this trade. Now there are a few exceptions we can talk about here. First of all, you may have a 2.5 or higher reward to risk multiple if you’ve done your numbers and you know that you’re still profitable at that level.
Another exception is you might have more than one target. That’s fine if you chose $20.00 as a second target because that would increase your reward multiple. But don’t forget, just putting it on a chart doesn’t mean you hit it. You have to determine what your actual average winner is to determine your reward to risk multiple going forward. Remember, it makes no sense to set a reward multiple of three or higher if you’re only taking one and a half or lower.
Another way to take advantage of your reward to risk multiple is if you have the ability to shrink down and zoom in on a shorter time frame that you could get a better entry price. Potentially $17.00 or lower and you took depending on where the resistant levels are on a lower time frame, you might actually set your stop a little tighter. These are other issues that you have to look at to see if you have the ability to trade on shorter time frames. Just changing that number slightly will dramatically reduce the rewards risk multiple that you have set here. Again, all of these factors have to be according to your trading plan.
Your strategy and your chart set up are going to determine your initial reward to risk. You should know these things ahead of time. You need to have an entry, a stop and a target. The quality of your trade selections and how you manage them are going to determine your overall profit and loss. It doesn’t matter what numbers you come up with, as long as you have good trade selections and that you manage them properly according to your money management rules and your position sizing. These factors will determine your overall profit and loss.
It really is a game of numbers. Small changes are going to make big differences in your results. You saw that with the win percentage and the risk multiple. Just changing your risk multiple even slightly will increase your results dramatically. The same goes for your winning percentage and vice versa.
You need a solid understanding of the math behind trading. If you’re just trying to wing it, you’re almost always going to end in disaster. If you have no plan and no trading rules in place, then you’re really just gambling and that’s not really a safe way to approach the markets.