Managing Editor’s Note: We’re just a few hours away from our colleague Jeff Brown’s 24-Hour AI Fortunes event.
Tonight, Jeff is diving into the details behind a strange phenomenon that’s causing explosive 24-hour gains in a small group of stocks… and the artificial intelligence he’s leveraging to help spot these opportunities well before they happen.
This is not an event to miss, so just go here to automatically sign up to join Jeff at 8 p.m. ET tonight.
At the heart of every trading decision, a basic concept is at work. You’ll often see it referred to as “risk and reward.”
In a nutshell, you must decide how much you’re prepared to risk on a trade to generate an expected return. Without that decision, you’re just flying blind or living in hope.
That’s something we’re seeing a lot right now with folks who are piling into gold and silver. I’m guessing a lot of those folks don’t have a defined exit point if things take a negative turn.
And even if those precious metals keep going skyward, at what point do investors walk away and bank their profits? Without a profit target, greed can take over, and it’s only a matter of time before the market shakes you out.
Understanding this risk/reward equation is key to successful trading. But there’s more to it than initially meets the eye…
When you start trading, you need to be able to determine how much of your account you are willing to risk on a single trade. And after you’ve been trading for a bit, you need to know that your accumulated profits more than account for your losses over time. You can’t risk a run of losses putting you out of the game.
You also need to have a reasonable estimate of how much you might make on a trade.
Consider a trader who sets a risk/reward ratio of 1:2. That is, they’re prepared to risk $100 to make a profit of $200. They’ll only need to be right one-third of the time to be profitable. But it might be hard to regularly hit that profit target level if they’re trading in a short time frame, such as a day or less.
That’s why you need to adjust your risk/reward ratio for the time frame you’re trading. You must also account for differing market conditions (for example, trending versus choppy).
A day trader might use a 1:1 ratio (where they risk $100 for an expected $100 return). While they need to be right more than 50% of the time to be profitable, they have a better chance of reaching their profit target during their time frame.
On the other hand, for someone who likes to trend trade (holding a position for weeks or even months), a higher ratio like 1:3 or 1:4 might be suitable. They have enough time for a bigger move to play out.
Either way, the key is to establish a baseline risk/reward ratio. You can then fine-tune your choices as you analyze your trading results.
And there’s one more factor to keep in mind…
It’s important to understand the risk/reward ratio. But you also need to be confident in your win-rate over time.
A 1:5 risk/reward ratio sounds good in theory. Who wouldn’t risk $100 for the chance to make $500? But the ratio means little if your win rate doesn’t support it. Suddenly, that proposition sounds less appealing if you’re only winning one out of every 10 trades.
On the flipside, with a high enough win rate, you can be profitable even if your risk exceeds your reward.
That’s what we do at my option advisory, The S&P Trader, where we trade option spreads on the S&P 500. Since we launched in December 2020, we’ve done over 1,000 trades with a win rate of 80%. We’ve never had a losing year following this strategy.
The key is to understand that successful trading is a combination of understanding your risk/reward ratio and your win rate.
Without that, you’re just trading on hope. And that is never a long-term strategy for making money.
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict
Reading Trading With Larry Benedict will allow you to take a look into the mind of one of the market’s greatest traders. You’ll be able to recognize and take advantage of trends in the market in no time.
