Probability and Risk Reward Ratio
For traders like you and me, stocks are nothing but electronic symbols. I only use volatility and liquidity to choose what stocks I trade. I will talk about why we need volatility and liquidity in the future. They are very easy to understand. The focus of today’s topic is Probability and Risk Reward Ratio (R-R-R). These two elements are a very crucial part of our trading career.
First, let me use a simple game to illustrate what probability is in trading. We all know that the probability of an outcome of flipping a coin is 50%. If you bet a rupee on the head and I bet a rupee on the tail. No matter how many times we play the game, we would break even in the end since the probability is 50%. Neither of us has an edge over the other. However, if you somehow increase your probability to 51%, you would beat me in the end. That is how casinos make money. Most people who go to casinos lose eventually. The house is always a winner since the odds are in the house’s favor. That is a probability.
Now let’s change the rules of the game. If you win, you make 2 dollars and if you lose, you lose 1 dollar. In other words, you risk a dollar to make 2 dollars. As for me, the rules are still the same. I risk one dollar to make one dollar. Your R-R-R becomes 1:2. Mine is 1:1. Probability is still 50%. It is not hard to see you will take all my money quickly. That is risk-reward-ratio.
Trading is not a zero-sum game since you will have to pay commissions to your broker. Even if your probability is 50% and Risk Reward ratio is 1:1, you’d still lose. So trading is a little bit harder than flipping a coin. Now it is quite obvious what we need to improve here. If you can prove that the accuracy of your system is over 55 percent no matter how the market behaves and your Risk Reward ratio is 1:1, then what a brain surgeon makes would seem like peanuts to you. It seems easy to trade with a Risk Reward Ratio of 1:1 since you really do not have to wait for a stock to move that much. However, the accuracy of your system is what you need to work on and it is extremely hard.
Another way is to put up with your poor accuracy and increase your Risk Reward ratio. As you can see from the day I traded BHEL, my accuracy was pathetically low. There were 4 trades. Only one made it. However, I still made some good money (percentage wise 3%). If I had traded 50,000 for each position, I would have been up rupee 1500 that day. Of course, most of your positions will fail since it is hard for them to move such a large distance. This methodology will test if you have mastered the time and battle proven strategy, which is cut your losers and let your winners run. Trust me. Holding onto your winners is much harder than cutting your losers.
Of course, if you had a system that has an accuracy of 55% and a Risk Reward ratio of 1:2, I think you would be richer than Warren Buffet in the foreseeable future.
If you are a newbie
you might not have understood all that what has been written above, So let me show you plain mathematics which will open your eyes.
Let us assume you did a total of 10 trades. In 9 trades out of 10, you won and earned rupee 100 each. In 1 trade, you lost 1000 rupee. So, the result is a loss of 100 rupees even after your accuracy was 90%. This shows how important is to maintain a risk reward ratio. Only one bad trade can vanish your good efforts.
Let’s see another example, Where you lose 4 trades out of 10 trades and have an accuracy of 60%, rupee but your 4 losses were not big because you maintained a max. loss stop loss. even after losing 40% of the trades, you are still in profits of rupees. Isn’t this great. That too when I have shown R-R-R as 1:1. Imagine when your risk reward ratio goes up to 1:2 or above.