Many traders discuss reward/risk as they are developing and executing a trade. However, few understand how to keep a positive reward/risk profile throughout the trade.
For example, let’s follow Steve. He wants to purchase an E-mini S&P (ES) contract as he believes it will rise in price. He has $50,000 in his account and is willing to risk 2% of his account on the trade, or $1,000 ($50,000 x 2% = $1,000). One thousand dollars of risk per one contract in the ES is 20 points (20 points x $50 per point = $1,000 – excluding commission and fees). It currently trades at 1200. He places an order to purchase one contract at 1200 with a reward/risk of 4:1. Accordingly, he places a sell stop at 1180 and sell limit at 1280 (reward is 80 points, or $4,000, and his risk is 20 points, or $1,000). Steve now believes that he has managed his risk well because he defined the risk and set his target order.
The trade is executed, and two sessions later, the ES is trading at 1240. He is halfway to hitting his target and feels great about his trade. His sell stop remains at 1180 and his sell limit remains at 1280. The next morning, the quarterly GDP number is lower than expected; the market corrects sharply back to 1210. He still feels fine about the trade as he has 10 points of profit and is willing to keep his sell stop loose so the trade has some room to work. The next session brings more selling, and the ES now trades at 1195. Though slightly concerned, he sticks to his trade plan by keeping his sell stop intact at 1180. However, trades decrease again in the following session and his sell stop is executed at his price of 1180. He loses his full risk amount of 20 points, or $1,000.
Is this a good trade?
Many will conclude that it was not a good trade because he lost money. However, there are many reasons to why a trade can be good or bad. For instance, Steve had a plan and stuck to it. He had his reward/risk parameters defined. The flaw in the trade was an error in the risk management process throughout the trade. Let’s examine why.
He began the trade with a reward/risk parameter of 4:1. When the ES hit a price of 1240, he had 40 points of profit, but his reward/risk was no longer 4:1 – it was 2:3. He was now risking 60 points to make 40 points (40/60 or 2:3). So how should Steve overcome this?
If Steve wished to keep his reward/risk at 4:1 throughout the course of the trade, he would have to alter his sell stop as the market moves around. Let’s re-visit Steve when the market was trading at 1240. His sell stop was at 1180 and the sell limit at 1280. He is now risking 60 points to make 40 points. Since the reward was 40 points at this time, he must now shrink his risk from 60 points to only 10 points. As such, he needs to move his stop 10 points below the market to 1230.
He now has successfully kept his reward/risk at 4:1 as his potential reward is 40 points and risk is 10 points. When the next day’s GDP number came out, he would have been stopped out for a profit of 20 points (if there was no slippage and minus commission on fees).
By keeping a positive reward/risk throughout the trade, he would have turned a 20 point loss into a 30 point win, a change of $2,500 in his account.
Be aware of what your original reward/risk plan is and how the ratio is affected as the moves around.
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Stop Orders Risk Disclosure: Stop orders do not necessarily limit your loss to the stop price because stop orders, if the price is hit, become market orders and, depending on market conditions, the actual fill price can be different from the stop price. If a market reached its daily price fluctuation limit, a “limit move”, it may be impossible to execute a stop loss order.
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