Thursday, July 4, 2013

How to triple your upside by halving your risk

Reducing your risk can provide a disproportional benefit to your return through some mathematical wizardry.
Suppose, for example, you see the setup below, and you wish to trade the pinbar that has formed at the swing low. The pinbar is about 10 pips in length. Many traders would trade this setup by entering on the break of the pinbar, with a stop loss at the end of the long wick. For this example, suppose we trade this conservatively and aim for a 1:1 reward:risk ratio, so our profit target is 10 pips (the same size as our stop loss).

Suppose we trade this more aggressively, and decide to enter at the 50% level of the pinbar, while keeping our stop loss and profit target at the same locations. The size of our stop loss is now 5 pips, half of the original setup. Our profit target is now 15 pips, instead of 10. Our new reward:risk is now 3:1. Even though we've halved our stop loss, we've tripled the size of our reward.

With a bit of aggression, we've tripled our reward from the same setup.
Of course, this doesn't always work. Sometimes price may not retrace 50% at all, and we miss out on a profitable trade. Or price will simply smash its way through our entry and hit our stop loss. However, this shows the benefit of tight stop losses and the disproportionate benefit it provides to R:R ratios. Remember, it's not about how many pips we win or lose, but how big our reward is relative to our losses.

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