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"Reward to Risk Ratio - What's That?" When we buy a lottery ticket we focus on a dream of a big reward. If we focused on risk (or probability of losing) maybe we would not buy a ticket. If we looked at reward to risk ratio, we would probably look to sell tickets not not buy tickets! Tom was no exception - he was a stock trader and had worked hard to increase his rewards, and had honed his entry and exit to the point where he was particularly profitable; but he had largely ignored his risks. In fact Tom had not even heard of the concept of risk or ruin, let alone calculated one, or used his acceptable risk of ruin to determine his position size. But there was no doubt Tom was a very successful stock trader. He had built his trading to the point where he could live on the profits easily. It had not always been this way. He first asked for coaching assistance because he did not like the run of three losing months he had one autumn. His personal history was one we are all thankful is not our personal history. His parents died in a car crash, soon afterwards his wife became bed-bound with cancer and died two years later. Fortunately, the rental income from his parents property meant he could be at home full-time to look after his two lovely daughters (then aged 6 and 9). It also gave him the capital and opportunity to trade from home - trading had been a passion that had been on hold when building a family and in a full-time selling job that saw him in hotels 60 nights a year. Tom had found that he had good skills at timing purchases of stocks, eventually honing his skills in two stocks in particular. He always traded from the long side and had built up his skills to the point that he rarely had a losing month. So when three losing months in a row occurred in 1997, he looked for help. We will call the two stocks Tom traded Intel and IBM, for this helps smooth the discussion. In reality they were stocks in the Nasdaq and DOW but not Intel and IBM. Tom had traded Intel for years - most of his profits came from Intel. It was quite a shock to lose money trading Intel four months in a row (IBM came to the rescue in the first month). Tom had not had even two losing months in a row before. Since Tom had not calculated his risk of ruin, he was not sure if it he was 'losing it' or the market had changed, or if this was just a normal and expected occurrence for his trading system. In reality his loss of confidence and fear was too strong - he was close to panic. Besides deep breaths in the short term, fact gathering and rational activity are some of the best long term cures for panic. Using a very simple starter spreadsheet, (available free from TradersCALM), Tom used his trading log to compare his history of Intel trades with the performance of the Nasdaq 100 index for each period of his open trades. The results were amazing - he out-performed the index in 56 out of 63 trades. A second level investigation gave more amazing results: his out-performance was 0.8% per trading day over and above any movement in the benchmark index. This might not sound much, but over his average two week holding period, this meant if his stock was priced at 100 when he bought it, he would sell it at 108 plus or minus any percentage change in the Nasdaq. What has this got to do with reward to risk ratios? An opportunity to increase the reward to risk ratio is beginning to stare you in the face if you are used to looking for such opportunities. In about half of the periods that Tom held Intel, the Nasdaq was falling, eating into his profits. Most of the 7 losing trades were in periods of big market falls - in all but one of his trades Intel out-performed the index or just kept pace. It was suggested that he had impressive out-performance skills for Intel trading - he was was not just riding on the back of a rising market as are many stock traders playing from the long side. So if he had traded Intel and sold an equivalent amount of the index each time, his results would have been: • slightly lower overall profits, • only one losing trade out of 63 trades, • dramatic increase in reward to risk ratio, • no period of three losing months. He could slowly, and steadily, leverage his improved reward to risk ratio and the accumulating profits in his account, to increase his trading size, to make his profits higher than before and with lower risk. His broker turned out to be supportive and he tripled his average monthly profit in Intel - he was now more comfortable with a bigger trading size than he was before with a lower trading size. But what about IBM? Another story completely. A similar analysis showed that his IBM purchases, although profitable, rarely out-performed the DOW. In fact, if he had bought an equivalent value in the DOW for each holding period of IBM, he would have made more money. For reasons that will become apparent, Tom was asked to compare his IBM results with the Nasdaq 100. The results were similar - buying the Nasdaq instead of IBM would have yielded twice the profit overall of buying IBM. Tom was then quizzed as to how often he held positions in Intel and IBM at the same time - the answer was about 20% the time he took an Intel position, he also purchased IBM and typically held both positions for about the same time. So it was suggested he could increase his reward to risk ratio further by: • buying the Nasdaq whenever he would have bought IBM, • using this, 20% of the time to partly offset any short Nasdaq position taken when trading Intel. When he back-tested this approach, his reward to risk ratio nearly doubled again. In practice, Tom found that his actual results were 15% better than the back-tested results. He could not imagine going back to just trading stocks. Some time later, now that his IBM profits were higher (using Nasdaq instead), it was suggested that he could slightly increase his reward to risk ratio by increasing the offset he used (equivalent to increasing trade size in IBM). But by now, Tom was into improving his reward to risk ratio - Tom had not only thought of this, he had implemented it, as well as two other techniques to improve his reward to risk ratio to the point where he was making 7 times his original profits, while his risk of ruin (an idea he just loved) had actually fallen. So Tom had moved from a simplistic reward focus to spreads, to position sizing based on risk of ruin derivations, to position sizing 'IBM' and Intel based trades. His confidence was now at an all time high - and it was based on experience and learning, not ego. His comment summed it all up: "I cannot believe I was dumb enough to trade the way I did, thanks a million." Lessons Learnt Many people spend much of their lives focusing on reward, with a lesser focus on risk, and often none on reward to risk ratio. When perceptions are opened, some traders transform themselves and become highly focussed on improving their reward to risk ratios. Successful traders, in their drive to improve their reward to risk ratios, often discard systems that their less successful fellow traders would die for. It is nice to be part of such an awakening. |