Measuring Reward for Risk
Stockscores.com Perspectives for the week ending November 17, 2013
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In this week's issue:
Stockscores Market Minutes Video
It is important to judge the success of a trade in terms of reward for the risk taken. In this week's Market Minutes video, I demonstrate what reward for risk is and how to draw reward for risk lines on the Stockscores charts. Watch the video on Youtube by clicking here.
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Reward for Risk
Traders acknowledge their profitable trades in terms of money made or percentage gain earned. It is far less common to measure the success of a trade by the reward earned for the risk taken. Yet, this is a far better measure of success because it recognizes that not all trades end profitably and it is important to consistently have trades with profits that are greater than the typical loss.
Consider two different traders. The first is profitable on 90% of his trades, making an average of $500 on each. The second is right 70% of the time and also makes an average of $500 on each trade. Most would say that the first trader is better.
But what about the inevitable losses? What if the first trader loses $5000 on the 10% of trades when he is wrong while the second trader limits losses to only $100 on her losing trades, which happen 30% of the time?
We know that the first trader actually loses money over time despite being right 90% of the time. The second trader makes a good profit over a large number of trades because the average profit is five times larger than the average loss.
The risk of the trade is the difference between your entry price and where you plan on taking a loss if the market proves you wrong. Limiting your losses with a price level where you intend to stop the size of the loss is a must for any trading strategy.
The reward of the trade is the difference between your exit and entry prices, assuming you exit at a profit.
So, if you buy a stock at $5 with a stop loss at $4.50 and then exit that trade at $7.50, you have earned a reward for risk of 5 to 1. The risk is $0.50 a share, the reward is $2.50.
Advanced and Pro Members of Stockscores can use the Risk Calculator tool to calculate their Reward for Risk ratio. Free users of Stockscores.com can plot the reward for risk lines on their charts. To do so, first open a chart by entering the symbol in the upper right hand corner of the site.
Next, go in to the Charting tab and enter the entry and stop loss prices in the boxes at the bottom of this tab below Risk/Reward. Click on create chart and the lines will appear.
You can see a visual example of how I do this in this week's Market Minutes video.
It is important for all traders, short or long term, to track the Reward for Risk ratios on all of their trades. This metric, combined with success rate, provides a true picture of trading success.
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This week, I went in search of stocks that are making gains on a weekly chart from a predictive chart pattern. To do that, I used the Stockscores Market Scan with the following settings:
Exchange = All Canadian or All American
Sentiment Stockscore > 60
Gain/Loss over the past 10 days = > 5%
Number of trades > 250 for Canadian markets and > 1000 for American markets
I then inspect the 3 year, weekly chart of the stocks found and focus my attention on stocks that are breaking from low volatility and optimistic chart patterns (like an ascending triangle).
Here are a few stocks to consider:
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1. T.EFN
T.EFN has been trending sideways for the past few months after making a strong upward trend through the first part of 2013. This week, the stock was able to break to new highs on increased volume, a sign that it is ready to start the next leg of the upward trend. Support at $12.75.
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2. OPXA
OPXA came alive on Friday with abnormal price and volume activity. It may stall at $2.40 resistance but should be minor if the abnormal volume continues. The sector is hot which also helps this stock's chances. Support at $1.99. (disclosure: I purchased this stock as a swing trade on Friday)
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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.
Scan the market using extensive filter criteria.
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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