Understanding risk-reward

In almost all my posts I insist that you can never avoid losing money in trading. Some people find it incongruous, and I’ve been asked several questions about this assertion.

The truth is prices move up and down, sometimes unexpectedly, sometimes with fluctuations larger that you had foreseen, and you might get caught up in the turmoil.?

You can’t control the markets; you can only control your expectations.

As a trader, your responsibilities are:

• to adopt a risk management strategy that cuts your losses short and lets your profits run;
• to have a thorough checklist of criteria to screen the markets and decide which positions you will open/close;
• to be consistent with your investment criteria, having the courage to decide not to invest if all requirements aren't met or if you have difficulty in spotting the trend;
• to always define a reasonable profit target for each trade;
• to always define a precise stop loss limit for each trade;
• to leave your emotions out of trading.?

Even if you are disciplined, pragmatic and consistent “sh** can happen” and you can be stopped out of a trade, losing money. That happens all the time to any trader, professional or not.?

The question you must ask yourself when you lose money is: “was it because of me or was it because of the market?”

Having the capacity to perform such self-analysis requires stamina and bravery. You must be proficient in self-awareness, maybe have undertaken some coaching sessions, but above all:

You must have a rational framework that keeps you focused on the process, regardless of the results

This simple rule applies to anything in life, from quitting smoking to losing weight. If you are not persistent, if you give up when results don’t show up as you expected, then you’ll never be able to continue your journey and reach for the goal you aim.

In trading, to assure you get the results you seek, you must understand the risk-reward ratio concept. Investopedia has a comprehensive explanation of the concept, so I’ll just jump into the practical description:?

First things first: you can never be a trader if you are not risk tolerant.

Risk is a part of the business, and you must accept that to increase reward you must also raise the risk you are willing to undertake.?

Let’s say you have $250 you are willing to invest in trading (I use USD because all platforms I work with trade in US dollars). If your risk-reward ratio is 2:1, your take profit target is 20% and your stop loss limit is 10%, meaning you will sell your position when your margin is 20% of the entry price but you will also sell your position if your loss reaches 10% of the entry price.

If you split your money between 5 deals of $50 each, you will exit with a gain when your profit is $10 but you will also exit when your loss is $5. Luckily all platforms I know allow you to define take profit and stop loss price levels in the moment you open the deal. This is truly an advantage for traders because, as human beings driven by emotions, we have an incomprehensible motivation for wanting to be right. Such impulse can make you fall into two terrible mistakes (been there, done that):

-???????You already reached your profit target but keep the deal open because your greed compels you to wish for more. The fact is that prices don’t follow infinitive trends so what goes up must come down, and vice-versa.

-???????You are losing money beyond your loss limit, but you keep the deal open because you believe the trend will reverse. The fact is it will reverse, but you’ll never know if you lose all your money because that happens.

So lets say you invest $250 in 5 deals of $50 and you had a profit in only 2 of them.

If you kept your 2:1 risk-reward ratio this means:

Profit = 2 deals x $10 = $20

Loss = 3 deals x $5 = $15

Net profit = $5

Since all platforms allow you to use leverage, you can easily multiply your gains (but also your losses) and reach your targets within a trading day (or within some hours or even minutes).

If you manage to have a daily profit of $5 a day, you’ll win $25 per week, what accounts roughly for $100 a month. This means a $250 investment can generate a $1.200 net profit in a year. I don’t know many investment alternatives that assure such returns.

The example I just gave is truthful. You should always start small, preferably on a demo account so you get acquainted with the platform and the markets. You can start with just 5 assets and become an expert in trading those 5. Remember you can trade long or short which means you can make a profit when prices go up but also when prices go down.

Before starting just be sure you know the basics about technical analysis, you have some understanding of the markets you want to trade and the correlations that affect them, and, above all, adopt a defensive strategy that grants you limited risk for precise results.