The Risk Reward Matrix
Stockscores.com Perspectives for the week ending August 21, 2005
In this week's issue:
What is the expected pay off of your trade? This is a question you should ask before entering any position. Understanding the payoff matrix will help you determine your exit strategy and the worthiness of the trade.
There are three components to the payoff matrix:
Risk
Reward
Probability
The risk of the trade is how much you will lose if you are wrong. Most of the time, this is the difference between the entry price and the stop loss price. However, you should also consider the potential slippage and the possibility of a price gap that could cause you to have an exit far below your stop loss point. When holding stocks overnight, price gaps are a possibility but only a very minor consideration when day trading since price gaps rarely occur intraday.
The reward of the trade represents the potential gain. If you are buying a stock below an area of important resistance, then you should consider the upside potential limited by the resistance. If there is no resistance on the chart then there is no technical limit on upside potential.
Finally, we should consider the probability of the trade working, which is, the probability of hitting its reward potential versus the chance the trade gets stopped out. The probability of the trade is dependant upon market conditions, the chart pattern set up, the stock's sector strength, the liquidity of the stock and the market's perception of the company's fundamentals.
Do you consider risk, reward and probability for every trade? Here is an example of how the pay off matrix is put in to effect.
You are considering buying a stock at $20. Technical support for the stock is at $19 so you plan to set your stop at $18.70. The chart pattern is an ascending triangle but there is resistance from 8 months ago at $23. Here are the important numbers:
Entry Price - $20
Stop Loss - $18.75
Risk - $1.25 per share
Resistance - $23
Reward Potential - $3
Probability of hitting resistance - 70%
Probability of going beyond resistance - 30%
Probability of getting stopped out - 30%
Probability of at least a $1.25 gain - 85%
Consider the potential pay offs of the trade:
Scenario 1
Expected value of the trade assuming an exit at resistance ($23) = $3 x .70 - $1.25 x .30 = $1.73
Scenario 2
Expected value of the trade assuming an exit at a $1.25 gain = $1.25 x .85 - $1.25 x.15 =
$0.88
Scenario 3
Expected value of the trade assuming a break through resistance = ($3 + unknown amount) x 0.30 - $1.25 x .30 + unknown x 0.40
Unknown
Scenario 1 has the best expected value based but Scenario 3 could be the winner depending on where the exit point comes out. If the stock makes a strong break through resistance at $23 it could head for $30 but it could also make a bull trap breakout through resistance and then fall quickly as stops get triggered and go all the way down to the stop loss point leading to a loss.
What these three scenarios show is that there is a good deal of uncertainty in trading and the trader has a complex job when calculating risk and reward. Understanding the probability of a trade requires a good deal of experience and estimating all the variables in the risk reward calculation is a daunting task.
What is important, whether you are experienced in making these calculations or not, is how to think about a trade. Don't take a trade unless the risk reward scenario is favorable and yields a positive expected value. Realize that, because of uncertainty, it is necessary to have a very positive expected value for every trade.
Beyond the arithmetic of calculating the risk-reward, it is also important to understand the psychological and money management effects of your trading outcome. While the second scenario may not have as high of an expected value, there is psychological value in being right 85% of the time with your trades. It is also more likely that you will not be in the trade as long with scenario 2 allowing you to turn your capital over more and potential make more profitable trades over the long run.
What this discussion emphasizes is what I like to tell all of my students; trading the stock market is simple, but not easy. The arithmetic above is taught before most people hit puberty but the art of judging the input variables is something that takes hundreds if not thousands of trades to understand. Make sure that you understand the three components of risk and reward before you make another trade.
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Pessimism is best represented on a stock chart by falling tops. Falling tops indicate that, over time, sellers are gaining strength and buyers are losing their motivation. When stocks consolidate with falling tops, the pessimism is complemented by growing consensus on what the stock is worth. As a market comes to consensus above a support price, a potential trading opportunity takes shape.
We get a signal that the bears have taken hold of a stock when three phases have run their course.
The upward trend line has been broken
A price consolidation has evolved, preferably with a falling top signaling pessimism.
A penetration of support occurs.
A good short selling opportunity occurs when these three criteria appear, particularly on stocks that have made considerable price gains in the most recent three to six months. As traders take profits off of the table, and fear begins to build among owners of the stock, the downward momentum in the stock can increase, creating a profitable trade for the short seller that established a position on the breakdown.
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1. TXN
TXN is hitting long term resistance and has broken down from a short term falling top. It looks like the mood of investors is changing from optimism to pessimism and that may bring a pull back in the weeks to come, perhaps back to $28.
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2. CHS
CHS has also broken down from a short term falling top pattern on strong volume, indicating investors have found something to be worried about. We may see a short term bounce back as momentum players look for a bargain, but I think the break of the upward trend line will evolve in to more of a pull back.
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References
Get the Stockscore on any of over 20,000 North American stocks.
Background on the theories used by Stockscores.
Strategies that can help you find new opportunities.
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Build a portfolio of stocks and view a slide show of their charts.
See which sectors are leading the market, and their components.
Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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