Over the last few weeks I've been writing about elements I believe a trader needs to consider and, perhaps, include in a trading business plan. Those elements of obtaining knowledge, exercising discipline, being patient, managing money, having an exit strategy before entering a trade, and identifying reward to risk potential are, to my mind, extremely important in attempting to create a successful trading business. They are much more important to my way of thinking than almost anything else I do as a trader yet some or all of them are overlooked by a large number of people who try to trade.
I wrote relatively extensively in my first book, "Trade Your Way to Wealth," about the creation and content of a plan. In my estimation, the first requisite is to have one; a plan, that is. A large proportion of coaching students who have visited with me came with no plan and that, I believe, is one of the critical reasons their trading had not gone well before our sessions. If we agree that discipline is a critical element of successful trading, we necessarily must have some plan otherwise there is nothing for us to discipline ourselves to do. Just buying or selling a stock requires no plan in and of itself, but buying a stock exposes us to risk, sometimes very high risk, and it seems we should at least incorporate a plan of exit strategy in case the play goes against us. In other terms that might be called a plan to cut losses. So, too, it seems basic that we should also have a plan of what we are going to do if the play moves favorably. How will we go about letting profits run or will we voluntarily cut them at some point?
After last weekend's article, a subscriber asked on the blog how one goes about calculating reward to risk ratios. I have suggested that traders incorporate that element of reward to risk potential in their trades since it can help achieve profits and keep us in the game more easily even if we suffer some string of losses (as almost all traders ultimately experience). In general I would contend that reward to risk should at least be considered as an element in any trading plan. What specific ratio might be chosen is up to the individual. 1:1, as I wrote last weekend might not be the best since if we are successful on only half our trades we will ultimately go broke because of commissions. In that case, we would lose a dollar, win a dollar, etc., but while our actual trades might break even, each would result in a commission so ultimately the account would be drawn to nothing. On the other hand, a reward to risk of 2.5:1 might assure that we could lose 7 trades out of 10 yet still make a profit. A reward to risk of 20:1 would be wonderful, but might be very difficult to find. The idea, then, is for a trader to incorporate a reward to risk that fits his particular trading personality and needs.
Using reward to risk analysis before making a trade provides no guarantee. It only helps the trader reach a decision of what the potential reward to risk might be. To make the calculation, I simply measure the distance from my entry to my initial exit strategy that might be the break of a price support or trend support for example and then compare that distance to the distance from my entry to the next area of apparent resistance (in a bullish trade). As an example, if I were to buy XYZ at $20 with a price support at $19 and the next apparent overhead resistance at $23, the potential reward might be $3 and the risk $1 for a 3:1 ratio. Of course, it is important to realize that these are just tools and because we see a support at $19 doesn't mean that we couldn't suffer a larger loss, for example, if some bad news came out and the stock gapped down to $15. Similarly, just because there is some resistance at $23 doesn't necessarily mean it's time to get out when the stock hits that level because it might keep on going. The calculation is simply a helpful element in attempting to gain some small edge in trading and while it is not going to work all the time, it can help make better trades.
Finally, when writing about the necessity of having a plan, I want to emphasize that each plan is likely to be different. That is why I never reveal the specific contents of my own plan though I have always been happy to discuss the elements I include. The specifics of the plan are for each individual to decide and are unique to him. Trying to copy my plan, for example, simply is unlikely to work since my risk tolerance, account size, knowledge, time devoted to trading and trading practice, patience, discipline, emotional reactions, goals, etc. are necessarily going to be different from those of every other trader as he creates his own plan. In fact, that is the paramount reason I have been writing this recent series of articles about what I consider to be important trading elements. They are offered as food for your thought with the hope that you critique the ideas for your own possible use. I'm guessing that it will be your own thoughtfulness or lack thereof that will ultimately help decide how well your trading goes. By that, I do not mean to encourage indecision because as we will see in a future article, indecision can also be a trader's enemy.
by Bill Kraft, Editor
Copyright 2010, Makin' Hay, Inc.
All Rights Reserved
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