Risk and reward is the name of the game when it comes to successful and even not-so-successful trading. But what makes some risks worth pursuing and others to be avoided at all costs?
Before entering into any position investors should always determine the risk/reward ratio of the trade; a simple comparison between the expected return and the risk taken to land that return.
All risk/reward analyses require a stop-loss to be placed on the position in order to give a lower bound to the investment, that is to say the risk element. This is then compared to what the trader stands to profit upon closing the position.
For example, an investor buys 1,000 shares (the quantity has no effect on the calculation) at $10 a share with a stop-loss order at $5. The stop-loss order protects the investor from losing more than $5 per share. If the investor were to expect those shares to climb to $20, they would be risking a possible loss of $5 to earn $10, per share—$5 against $10 or a risk/reward ratio of 1:2.
There is no such thing as a risk-free investment. Riskier investments require a greater return to make them worthwhile but how attractive a risk/reward ratio and in turn a trade is, depends wholly on the trading strategy being applied. An investment where the potential return is equal to the risk, carries a 1:1 risk/reward ratio and would not be considered as attractive as ratios of 1:3 or more.
Risk/reward ratios can be seen in play in the real world away from the markets. Nassim Nicholas Taleb discusses in his book, ‘Skin in the Game’, how he believes a problem we face in the modern world is that those in power have huge potential rewards for sometimes non-existent risks. That is to say that they can gamble with the livelihoods of entire populations without any personal culpability or liability.
If you play free online blackjack for only a few hands you can quickly absorb the simple concept of risk and reward. Winning your hand against the dealer will win you back your original bet plus winnings equal to your bet, a 1:1 risk reward. If you push (draw), you keep your money and if you get blackjack you receive 1.5 times the amount wagered i.e. a risk/reward ratio of 1:1.5 or 2:3.
When you see casinos stating “Blackjack pays 3 to 2”, that ratio is the payout to which they are referring. Many casinos have begun offering 6 to 5 (a risk/reward ratio of 5:6) on blackjacks which significantly increases the house edge. Very rarely these days will you stumble across a table that pays 2 to 1 for blackjack because this essentially gives the player the edge over the house, but if you do see it, don’t pass up the opportunity. These simple ratios show the similarities between blackjack and trading stocks.
However, the risk/reward ratio is not enough on its own to determine whether a trade is attractive or not. It also depends on expectancy or probability of success.
The risk/reward ratio can be manipulated by setting a stop-loss order closer to the opening position, effectively reducing the risk of the investment. This of course comes at a price—the trade is less likely to be successful. If the asset moves in an unexpected direction away from the starting position there is less room for the stock to bounce back before the stop-loss order is reached and the position is closed at a loss. While the investment is less risky, it is less likely to be successful. This is an example of expectancy
Back to the blackjack table. If you are gambling on a 1:1 risk/reward ratio you would need to have a success rate of 50% to turn a profit. You cannot change your bet and you cannot stand to win any more money after the cards have been dealt so the risk/reward remains unchanged, but choosing to hit or stand will depend on the win probability of your hand against the dealer’s.
Professional poker players are experts of internalizing risk/reward ratios for the hands they have against their opponents and also learn what percentage of the pot to bet based on the likelihood of their cards winning. Poker becomes more complex than blackjack since the risk/reward ratio constantly changes with each round of bets and depends on how many other players are also declared in.
All of life’s big decisions come with an element of risk, be that on the sports field, in the office or family decisions at home. And like in trading, it’s important to mitigate any major risks that would affect your primary objectives and consequently your successes. At least when navigating the markets, the risks are usually more obvious and quantifiable.
By Jane Hardy