Risk and reward: trading and financial risk management
Rewards from trading require risk and making sure potential rewards justify the risks involved is crucial. Trading and financial risk management means establishing the potential risk/reward balance and using tools to help mitigate those risks.
IN A FEW WORDS
Trading risk management Financial risk management Risk/reward ratio Win/loss ratio Stop loss
4 min reading
“Picking up pennies in front of a steamroller” – this famously described a hedge fund strategy with a high chance of a small return, but a small probability of a vast loss. It describes the very worst kind of trade – little upside and lots of potential downside. While there is no reward without risk, traders need to ensure that potential rewards justify the risks. In other words, if you’re taking your chances with a steamroller, you need to make sure it’s for more than pennies.
Even if it seems like the surest of sure things, every trade comes with risk, making trading and financial risk management essential. The pandemic has amply demonstrated how financial risk can appear suddenly and unexpectedly, derailing an apparently unassailable trading strategy. While it is not possible to anticipate every potential crisis, it is possible to calculate an approximate risk/reward figure for every trade. This also allows you to make comparisons across trades.
Understanding the risk/reward ratio of your trades
The key metric is the risk/reward ratio (also known as the R/R ratio), a measurement of the potential profit to potential loss of an individual trade. A trader’s first step is to establish the potential upside and downside for the trade based on the current price and expected return. You will then need to set a stop loss to cap the downside.
From there, you can divide the difference between the starting point of the trade and the stop loss order by the difference between the starting point and the profit target. This should give you a relative risk figure to help with your trading and financial risk management decision making.
For example, if Apple shares are trading at $140 per share, you may believe they could go to $180, based on current trading. However, you recognise that if the latest product cycle doesn’t fly as expected, they could drop to $120. This is where you place your stop loss. In this example, the risk/reward ratio would be: (140-120)/(180-140)=20/40=0.5. Most traders aim to find trades with ratios below 1.0 and in practice, most aim for lower than 0.5% - i.e. more than 2x upside for 1x downside.
It is also worth looking at the aggregate risk/reward across all your trades. It’s no use winning small on lots of trades only to sacrifice your profits on a single large trade.
Your trading risk/reward ratio doesn’t have to be static. You can vary the stop loss, for example, to improve the ratio. That said, you should assign the stop loss logically and not seek to flatter the risk/reward ratio on a trade that doesn’t have a lot of upside. The parameters of a trade should always be based on your strategy and analysis rather than randomly assigned.
Risk/reward in combination
Equally, the risk/reward ratio won’t be enough on its own to decide whether a trade is worth doing. You also need to assess how likely it is that the trade hits its targets. After all, a trade may have great risk/reward ratio, but if it has a limited chance of hitting the high price and a far higher chance of dropping 10%, it probably won’t be worthwhile.
It is also worth considering behavioural biases when setting the parameters for your trade. Are you looking objectively at the value of the security and current market conditions? Or are you anchoring to previous price expectations or recent market activity? Any risk/reward calculation needs to be part of a broader trading plan.
Trading and financial risk management
When it comes to trading and financial risk management, there are other metrics you can bring in to determine whether to proceed with a trade. The win/loss ratio (or win rate) for example, compares the number of winning trades with the number of losing trades. This helps establish whether your profits are coming from a handful of big winners, or whether you have actually built a successful strategy.
The break-even percentage shows the number of trades that need to work out for you to break even at any given point. If only 20% of your trades need to go right for you to break even, that’s a lot better than needing 80% of your trades to work out for the same result. Most traders are looking to make money rather than simply break even, but it can give an indication of whether you are trading successfully.
Don’t forget trading costs when calculating your risk/reward ratio. High costs can exert a drag on your trading profits and increase your risks.
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