In this Article, we will discuss the importance of managing risks and rewards
in trading. We’ll explore how slight changes in our entry or exit points can
affect our risk and potential rewards.
Mastering Risk-Reward ratio in Trading: A Complete Guide
Before diving into Risk-Reward ratio management, let’s understand what Positioning means. When people trade in the stock market, they decide how much of a particular stock to buy based on their capital or capacity. So, the question is, how do they determine the quantity based on their capital?
They typically think in terms of the stock price. For example, if a stock is expensive, let’s say it is trading at Rs. 3000, they might decide to buy 10 shares. If the price is Rs. 2000, they might buy 15 shares. And if the price is less than Rs. 1000, they might go for 30-40 shares. In essence, they buy fewer shares when the price is high and more shares when the price is low. Their positioning depends on the share price.
Now, let’s discuss two cases. Let’s assume that Raju is targeting a 1:1 risk-reward ratio. This means that if Raju enters in a trade and aims for a profit of Rs. 2000, he is willing to accept a loss of only Rs. 2000. In other words, He is ready to accept the loss equivalent to his targeted profit.
Case Studies: How Risk-Reward ratio Affects Your Profitability
Case 1: Raju bought 100 shares of a stock and set a stop loss at Rs. 20. This means that if the price drops and hits the stop loss, Raju will face a loss of Rs. 20 per share. If the stop loss gets hit, Raju’s total expected loss would be Rs. 2000 (100 * Rs. 20).
Case 2: In another trade, Raju enters and buys 100 shares with a stop loss of Rs. 40 per share. If the stop loss gets hit, Raju’s total expected loss would be Rs. 4000 (100 * Rs. 40).
Raju is a skilled trader with a 50% accuracy rate. Let’s say he booked a profit of Rs. 2000 in the first trade but incurs a loss of Rs. 4000 in the second trade.
Despite having a 50% accuracy rate, Raju ends up losing Rs. 2000 (4000-2000). In both cases, the quantity of shares was the same, but the stop loss was different. In case 1, the stop loss was tighter, and Raju achieved his target. However, in case 2, the stop loss was wider, and he had to book the loss also, due to market conditions.
In a 50% accuracy rate, it could have resulted in a break-even situation, means he could have ended up with no loss no profit situation but that didn’t happen. This issue arose due to position sizing; he had to bear a net loss of Rs. 2000. In case-2 stop loss was wider, Raju could have purchased 50 shares, which would have allowed Raju to control and limit their potential losses with in Rs.2000 range instead of Rs.4000.
Moving forward, we will no longer determine the quantity of our shares based on the price of the stock. We will focus on limiting our losses by using a stop loss range. This means that we will implement a risk management strategy to control and minimize the potential losses incurred in our trades.
Position Sizing Formula: How to Calculate Trade Quantity
Now, let’s consider the case of Raju, who has joined our program and has Rs.1 lakh capital in his Demat account. Raju is familiar with the entry point for trades, the stop loss level, and the target price for the stock.
First, let’s establish that Raju is willing to take a risk of Rs. 1000 per trade, which corresponds to 1% of his capital. With a capital of Rs. 1 lakh, the risk per trade would be Rs. 1000.
Now, here’s the formula for calculating the quantity to buy for each trade:
Quantity of a stock = Risk per trade ÷ (Entry – Stop loss)
In this case, the quantity would be 1000/20 = 50 shares.
Using this formula, we have determined the position size for each trade. In each trade, Raju would take a maximum loss of Rs. 1000 only if the stop loss gets triggered.
Position Sizing Formula: How to Calculate Trade Quantity
Below are the two common mistakes that beginner traders often make, and they repeat these steps again and again.
Mistake #1: Changing the Entry Price Too Often
Changing the entry level: Sometimes, when we see that the price is approaching our entry level and a red candle is formed in the stock, we get scared and change our mind. Instead of entering at the originally marked level, we decide to observe the trade and wait for a price reaction from the zone. Once the price reacts and goes up, we chase the trade to enter. By doing so, we shift our entry to a higher level, which increases the stop loss and decreases the target ratio. It’s important not to change the marked entry level once we have fixed the target, stop loss, and quantity to buy. Changing the entry will reduce our potential rewards.
Mistake #2: Holding Losing Trades Beyond Stop Loss
Sometimes, when the stop loss gets hit, we don’t exit from the trade and hope that it will recover. By doing this, we unnecessarily increase our losses. In this case, by not accepting the stop loss, we are indirectly changing our exit/stop loss from what was planned at the beginning of the trade. You can change the stop loss and entry before entering the trade, but once you are in the trade, you are not allowed to change the stop loss. The quantity you have bought is decided based on the predefined stop loss and entry. So, don’t change or break the rules once you are in the trade.
Essential Rules for Risk-reward ratio Management
- If you missed the entry, don’t chase the trade to enter.
- When the stop loss gets hit, many people tend to average down the stock instead of exiting from the trade. By averaging down multiple times, our mindset may change, and we might panic and exit the trade when the price comes back to the break-even point. If the trade hits the stop loss, don’t wait in the trade and expect the price to come back to your buying price.
- Don’t doubt your strategy or system if you experience three or more consecutive trade stop losses. It’s important to test every strategy on at least 50 trades. Similarly, don’t become overconfident if you achieve three consecutive targets in a row.
- If you want to short a stock, don’t sell futures or put options (PE). By doing so, you cannot limit your loss to 1%.
- Initially, focus on taking only 10 trades per month, and ensure that these 10 trades are of high quality. Filter out the 10 best trades in a month.
The importance of following predefined rules
To continue reading download the E-book on risk-reward ratio, in this e-book we have explained complete proof of concept.
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