Risk v. Reward

Fundamentals of Market Investing by Adam J. McKee

When we talk about “high probability” strategies, the novice will often conclude that we should always search for trades with very, very high probabilities such as 100% (these don’t exist outside of fixed income investments) or 95%.  The problem with this strategy is that there is no free lunch on Wall Street.  Other traders are willing to pay you money, but they will only do it in exchange for you taking risks.  If you are only willing to make bets that are very nearly “sure things,” then just invest in government bonds and hope they hedge inflation.  The ultimate task of traders is to balance risk with reward.  The payoffs for very high probability bets are so small that most traders consider them not worth doing.  For you to make substantial profits, you must take risks that at least some other traders are unwilling to take.

The other extreme is taking on so much risk that your losses outweigh your wins.  This is the sort of losing strategy that wipes out so many novice traders before they ever get a chance to develop a trading system that actually works.  This means that to be a profitable trader, you must consider how much capital you are putting at risk and what kind of reward that will generate for each trade you consider.  If you just guess, your likelihood of underestimating risk and overestimating reward is quite high.  It is worth the time to track your trades and understand this objectively.  The most common objective measure is the risk-reward ratio (RRR).

There is some confusion about RRRs because sometimes traders are referring to their personal average of all trades over time, and some traders are talking about a particular trade.  Ultimately, we are trying to answer the following question:  what is the potential loss compared to the potential gain?  We can express that as a fraction, such as ½.  This requires that we have actual numbers for both the maximum loss and the maximum (or expected) gain.  Stock traders can use trading tools such as stop-loss orders to set a numerical limit on losses.

Gains will often be forward-looking and must be estimated.  With stocks, traders will often use a price target.  If this is the case, then the estimation of the RRR will only be as accurate as the price target.  Obviously, this method has a wide margin of error.  Still, such a computation will prove more accurate than a mere optimistic guess.  A major advantage of risk defined options strategies is that since profit is numerically defined, precise RRRs can easily be calculated.

When examining the risk profile of individual trades, it is important to realize that the RRR is closely linked to the probability of success of the trade.  Over many trades, a trader can take higher levels of risk with correspondingly higher chances of winning.  Writings on probabilistic trade strategies often use games of chance analogies to explain the concepts of risk, reward, and probability.  Analogies are a fine teaching tool, but gambling analogies have a weakness in that they usually do not explicitly consider that the probability of profit with market trades varies greatly from trade to trade.

Games of chance tend to follow identical rules from game to game, and thus the win rate is a secondary consideration to the massive gains that come with a win despite the fact that a win is extremely unlikely.  We must remember that casinos remain solvent year after year because gamblers are willing to defy the odds consistently.  Obviously, traders cannot afford this fallacy.

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