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The Risk/Reward Ratio

Should You Concern Yourself With This?

 If you are a trader of Stocks and/or Commodities, you have heard mentioned from various sources and so-called educators something called the "Risk/Reward Ratio". According to one source, "Risk/Reward Ratio" is defined as;
 
 "A ratio used by many investors to compare the expected returns of an investment to the amount of risk undertaken to capture these returns."
 
 Evaluating risk is always an important part of investing and speculating. Before a trade is taken, it is prudent to determine if the risk is appropriate for the amount of available capital and whether there is good potential for reward by taking that risk.
 
 For many, the determination of whether a trade is worth taking is based on some hard and fast rule that the expected reward should be a certain increment of the risk. This is what many call the "Risk/Reward Ratio". For example, if the trader expects a trade will likely produce at least double the amount risked, this would be referred to as a 2:1 Risk/Reward Ratio. Many look for this ratio to be at least 3:1 before taking the trade.
 
 Oddly enough, the ratio itself does not match the description. For instance, a 3:1 Risk/Reward Ratio is meant to mean that the trade has the potential to produce profits that are three times greater than the risk. Seen in that light, however, should it not be called the Reward/Risk Ratio instead? By reference of Risk/Reward, you'd at least think traders would state the risk first followed by the expected profit potential. Unfortunately, this is not the case in the general trading populace.
 
 In any event, should trades be determined by such a ratio? While it is not difficult to decide on a percentage of overall funds that may be risked in order to follow a strict Money-Management plan, should the determination of whether to risk at all be laid upon the expectation that a trade will produce a certain multiple of risk?
 
 When you consider that it is virtually impossible to determine profit in advance, it all comes down to basing your decision to trade on an estimation. One definition of 'estimate' is;
 
 "A judgment based on one's impressions; an opinion."
 
 How far is that from "guessing"?
 
 Well, the difference is minor, but 'estimating' does imply that you have a tad more information to work with in order to arrive at an 'opinion', where 'guessing' usually based on "little or no information". But the difference is indeed small. Another way of saying 'estimation' is to say an "educated" guess.
 
 When we consider that the 'Reward' component of the "Risk/Reward Ratio" is a function of taking an 'educated guess', should our trading decisions be based on such a loosely defined criteria?
 
 Rather than base a trade on the amount of profit 'you think' you will gain from taking a trade, the decision should be based on the simple expectation of whether you expect a profit at all. The amount of profit should be left up to the market and whether you manage the trade effectively once it has commenced. However, it never hurts to at least get an idea of what the market may provide in potential profits at a minimum.
 
 While no method of 'estimating' potential profit is foolproof, we can logically make some pretty good 'educated' guesses. The following three examples should provide you with a good idea on how to go about this.
 
 We start by first determining whether a potential trade exists without regard to the amount of potential profit. This determination can be based on various factors that you have found effective. Since I am mostly familiar with my own way of timing the markets, we'll simply have to go with that.
 
 The first determination is whether the market is 'correcting'. Another term for this is a trend "pullback". In our first example (Chart 1), we can see that prices had been rising after breaking above a downward trend line that had been containing a bearish trend. This rise in price also successfully exceeded a previous swing top that was one of the tops used for that declining trend line. This, as W. D. Gann would say, was the first signal that a "change in trend" was likely occuring.

CHART 1


 
 Then the market started to decline again. This is our trend 'pullback/correction'. Up to this point, anyone with a price chart and the ability to draw trend lines can accomplish this. At this point, however, the method you use to time the market and the method I use may differ. So I will refer to my own method and you can replace that language with your own.
 
 Somewhere along this 'correction' it has been determined that there is very good potential for the retracement to end and for prices to start rising again. My determining this is with the use of cycle turn dates that allows for being within a single price bar accuracy of calculating when a market turn is likely. Confirmation of this expectation will then commit me into the trade. Before taking the trade, however, the risk is evaluated. What might my risk be?
 
 Considering that the expectation is for the retracement to have ended and that a swing bottom is highly likely at this time, and in addition that I will not commit to the trade unless the swing bottom confirms, my risk in this example would be the range of that swing bottom price bar. Therefore, in advance, I would know what my 'risk' would be.
 
 How about the reward?
 
 Again looking at Chart 1, note that the "minimum potential profit" is determined to be the point on the price chart where the retracement began. So if my trade entry is at price "A" and the correction started at "B", the 'minimum' estimated 'reward' would be from "A" to "B" in points.
 
 If this 'minimum' profit potential is acceptable for the amount of risk being taken, then the trade can be initiated. But it should be understood that this is simply the 'minimum' potential estimated. There is always the possibility, if you allow for it, to make greater profits. Also, by managing your stop-loss effectively, you can be reducing your risk exposure along the way. As your stop-loss is adjusted during the course of the trade, your risk shrinks and your profit potential continues to be a product of what the market is willing to provide.
 

 


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 Once your minimum profit target has been reached, you can continue to 'estimate' new logical targets. Chart 2 shows how you can get your next profit estimation. The technique here is to simply take the initial wave (range) that was used for your first profit estimate and add this range to where the retracement had ended. This is often referred to as an "Alternate-Expansion".

CHART 2


 
 If your trade continues to do well and that 'alternate' expansion level is reached, and assuming you have not been stopped out or prematurely exited your trade, you can then perform an 'extended' profit estimation. The technique is the same as the 'alternate' expansion technique just discussed, except that the initial 'wave' (range) is added to itself as shown in Chart 3.

CHART 3


 
 While these are very useful approaches to help determine 'reward', keep in mind that they are still 'educated' guesses at best. Do not get hung up on basing your trades on some fixed Risk/Reward Ratio as a means to determine whether a trade should be taken, but to simply determine first whether you have a potential trade and then determine whether the minimum amount of 'likely' profit would make the trade worth the risk in your opinion.
 
 Rick Ratchford
 ProfitMax Trading Inc.
 http://www.amazingaccuracy.com

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