I’m often asked what makes the perfect trade set-up in terms of risk vs reward. But it’s too easy to pick and choose from an abundance of share price charts when you have hindsight on your side. So my answer is always the same. Forget charts and share prices for a moment and let’s go back to basics.

Would you consider risking £10 of your own money in order to make another £10. If the answer is no, then you are saying that a reward to risk ratio of 1:1 is unattractive. Which makes sense. After all, you stand to make only as much as you stand to lose. In trading, this would equate to ignoring a trade that offers 5% potential upside but also has potential downside of 5%, your limit being equidistant from your stop loss. Not worth it. Unless it’s dead cert of course. But unfortunately financial markets seldom offer these.

Now I’ve written on risk vs reward before and mentioned that for all our natural human optimism we must consider the negatives too. Yes a trade can look good based on how much a share price could move in your favour. However, I cannot stress highly enough how paramount it is to decide how far you would also allow a share price to move against you before calling it a day. Only after you have both essential numbers are you able to calculate and decide whether a trade is worth it.

Something may well have 30% upside, but if it has 25% downside, you might want to review the idea. Yes you can avoid this by looking only at shares which have just bounced, offering more upside than downside, however, trying to call a bounce too early can also result in more risk if you have yet to see enough evidence of an actual bounce. As always timing is key. Not too early. Not too late.

Having established that 1:1 ratio is not worth it, the question can be asked again and again, replacing the £10 reward with £20, £30, £40 etc, for the same £10 risk. Returns of 2x, 3x, 4x and 5x are surely much more attractive. Because as much as it’s about making solid returns it’s also about making sure these returns can make up for the trades that go wrong. Because there will be losses. Of course there will. In many cases there will be more losers than winners. That just the way it goes. So it’s about making sure the bigger returns from the few winners can more than make up for the many smaller losses.

Now if you assume a 50% success rate on 10 trades, all of them with an unattractive reward to risk ratio of 1:1, then the 50% of winners will only offset the 50% of losers. A waste of time. Something needs to improve. Assuming you can’t change your success rate from 50%, what needs to change is your reward-to-risk ratio, by increasing what you stand to make versus what you stand to lose. Keeping success at 50% but moving to a 2:1 reward-to-risk ratio allows you get more trades wrong (60%) before your P&L goes negative. Keep raising the ratio all the way to 3:1  (a level deemed by many as ideal) with an unchanged 50% success rate and you could call as few as 30% of trades right and still turn an profit overall.

In summary, assuming an unrealistic success rate is dangerous enough. Focusing too much on what you could make from a trade versus what you might lose just makes things worse. After all if you keep taking chunky losses, your trading experience won’t be long standing. Remember, it’s as much about capital preservation as it is capital appreciation. Be honest with yourself. It’s your money your risking.

Analysing the markets and charts and is just one of my many jobs. Another is helping clients via educational material and topics such as the above. After all, it’s in our interest that our clients have a long and profitable trading lifetime.

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As always, enjoy your weekend.

Mike van Dulken, Head of Research, 22 Sept 2017