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Stockscores.com Perspectives for the week ending December 17, 2006
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Stockscores Trading Tip #1
Click Here to see a short video highlighting an important aspect of trading using the Stockscores Approach.
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In this week's issue:
Most of the time, we look at opportunities in the stock market and think about the likelihood that the stock will go in the direction that we want. Have you ever considered thinking about the stock opportunity in terms of risk versus reward?
What we usually do is consider buying a stock because we think it has a good chance of going up; perhaps we think that chance is 70%. What we don't think about is how much money we will make if it does go up versus the money we lose if it goes down. Why not work the equation in the other direction?
Instead of thinking about the chance of success, think about the profit you will make if you are right versus the loss you will suffer if you are wrong, and then decide what the probability of success has to be for the trade to be worth making.
Suppose I offer you two trades. For trade #1, you can buy ABC for $10, and you have a 70% chance it will go up to $12 and a 30% chance you will be stopped out at $8. For Trade #2, you can buy XYZ for $10 and if you are right, the stock will go up to $15 and if you are wrong, it be stopped out at $9. What does the probability of success have to be to make Trade #2 worth taking over Trade #1?
To answer that question, we have to first calculate the expected value of Trade #1. The expected value of a trade is the probability of profit times the profit - the probability of loss times the loss. For Trade #1, this is:
$2 times 0.70 minus $2 times 0.30 = $0.80
For Trade #2 to be preferred, we need its expected value to be greater than $0.80. Therefore:
Trade #2 Expected Value > $0.80
Which means:
$5 times the probability of profit - $1 times the probability of loss > $0.80
$5 times X minus $1 times 1 minus X > $0.80
If the probability of success is 30%, Trade #2 will have the same expected value of Trade #1,
$5 times 0.30 - $1 times 0.70 = $0.80
Therefore, if we think that Trade #2 has a better than 30% chance of providing a profit without getting stopped out, we should take that trade.
What is important is that we put the emphasis on the potential reward of the trade relative to its risk and then worked to decide if the probability of success is good enough to justify the trade.
I have seen many trades where the probability of success was very good but the risk if unsuccessful was too great to justify the trade. For example, if a stock is in a strong upward trend going in to an earnings announcement, it is likely that it will continue the upward trend after the earnings announcement. However, there is a small chance that the announcement will be bad news that will really shatter the market's expectations and the stock will fall significantly. Therefore, trades around earnings when the market expects good news are not worth taking because the reward for being right is far outweighed by the risk for being wrong.
Situations where you have a predictive chart set up that has proportionately less risk relative to the potential for reward are the best trades to take. This means being more selective in your research process by adding an extra dimension to how you evaluate the opportunity. It is not enough to have a trade that has a high probability of working, it also has to have much more reward if it does work relative to the risk of failure.
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This week, I went through charts of all the stocks that make up the Nasdaq 100 Index looking for trades that had a good risk reward ratio. Here is one that I think stands out and serves as a good example for this week's commentary.
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1. ADBE
ADBE ran up significantly over the past week but after gapping up on Friday, it closed below its open and looks like it may fall back to just above $40. A short trade from Friday's close of $42.75 has resistance at $43.25. That means the risk of being wrong on the short sell is $0.50. If the trade works, I think the stock falls back to $40.50, meaning the reward for the trade is $2.25. That gives this trade 4.5 times more reward potential than risk. Given the chart pattern, I think the probability of this short working is good enough to trade given the very nice risk reward ratio.
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References
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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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