Not mastering risk and reward in trading is probably the main reason why so many traders and investors are destined to fail. It's really dumb when you think about it, because reward/risk is the easiest way to get a definable edge on the market house.
The reward/risk equation builds a safety net around your open positions. It's designed to tell you how much can be won, or lost, on each trade you take. The secondary purpose is to remove emotion so you can focus squarely on the cold, hard numbers.
Let's look at 15 ways that reward/risk will improve your trading performance.
- 1. Every setup carries a directional probability that reflects a specific pattern. Always execute positions in the highest-odds direction. Exit your trades when a price fails to respond according to your expectations.
- Every setup has a price level that violates the pattern. Only take trades where price needs to move a short distance to hit this "risk target." Look the other way and find the "reward target" at the next support or resistance level. Trade positions with the highest reward target to risk target ratios.
- Markets move in trend and countertrend waves. Many traders panic during countertrends and exit good positions out of fear. After every trend in your favor, decide how much you're willing to give back when things turn against you.
- What you don't see will hurt you. Back up and look for past highs and lows your trade must pass through to get to the reward target. Each price level will present an obstacle that must be overcome.
- Time impacts reward/risk as efficiently as price. Choose a holding period based on the distance from your entry to the reward target. Then use price and time for stop-loss management. Also use time to exit trades even when price stops haven't been hit.
- Forgo marginal positions and wait for the best opportunities. Prepare to experience long periods of boredom between frantic surges of concentration. Expect to stand aside, wait and watch when the markets have nothing to offer.
- Good setups come in various shades of gray. Analyze conflicting information and jump in when enough ducks line up in a row. Often the best thing to do is calculate how much you'll lose if you're wrong, and then take the trade.
- Careful stock selection controls risk better than any stop-loss system. Realize that standing aside requires as much deliberation as an entry or an exit, and must be considered on every setup.
- Every trader has a different risk tolerance. Follow your natural tendencies rather than chasing the crowd. If you can't sleep at night, you're trading over your head and need to cut your risk.
- Never enter a position without knowing the exit. Trading is never a buy-and-hold exercise. Define your exit price in advance, and then stick to it when the stock gets there.
- Information doesn't equal profit. Charts evolve slowly from one setup to the next. In between, they emit noise in which elements of risk and reward conflict with each other.
- Don't be fooled by beginner's luck. Trading longevity requires strict self-discipline. It's easy to make money for short periods of time. The markets will take back every penny until you develop a sound risk-management plan.
- Enter positions at low risk and exit them at high risk. This often parallels to buying at support and selling at resistance, but it can also be used to trade momentum with safety and precision.
- Look to exit in wild times in order to increase your reward. Wait for price acceleration and feed your position into the hungry hands of other traders just as the price pushes into a high-risk zone.
- Manage risk on both sides of the trade. Focus on optimizing entry and exit points and specialize in single, direct price waves. Remember that the execution of low-risk entries into bad positions allows more flexibility than high-risk entries into good positions.
