We have talked in the past about having larger stop-loss threshholds than the actual expected reward, and the backlash on forums when this type of trade is even mentioned. The logic of the backlashers is that you have to have reward larger than your potential loss to win in the game of trading.

I wanted to explore the concept a little bit further and just think through the implications of what it means to put on a trade where your potential reward is smaller than your potential risk.

Let’s start with an example… If a stop is 2x the size of reward (e.g., a stop loss would be triggered at a loss of 10% but we’ve set a price target of 5%) then we have to get at least 70% of our trades correct to make money. (66.7% plus slippage and commissions, I’m guessing ~70% if not higher.) To me, this seems like a fairly high hurdle to start with, though it is certainly possible.

I don’t think it isn’t possible to trade a system that has a 2:1 risk:reward ratio, but it certainly can be difficult and you have to be right more than 3/4 of the time to make it profitable in the long run — possible, but difficult (but hey, everything is difficult).

One thing that might be worth doing is to review what all our options are regarding this situation. The obvious first choice is to not choose to trade a 2:1 risk:reward scenario, but that one is kind of a cop-out…

We might consider a tighter exit stop and a re-entry signal… that is, our initial stop loss might be 2% for the same 5% price target, but if we get stopped out we look for conditions to re-enter. Commissions and slippage would be higher if you wanted to go that route.

We might consider options to limit our risk more while still having exposure to the upside… If I can go long the XLF (financials) by buying calls instead of buying the XLF outright, I might be able to limit my risk in the options to 3-4% (depending on volatility, time value, etc.) instead of the full 10%.

We might also consider that if volatility is so high that a 10% swing to the downside is possible, maybe we should consider the reverse of our system. That is, when a buy signal is generated with a 5% profit target and a 10% stop loss, we sell with a 4% stop loss and a 8% price target. Probably not the best choice, but still an option and it would appease the fanatics in the peanut gallery by providing a 1:2 risk:reward ratio. [Note: not every alternative makes sense, but it doesn’t hurt to throw out nonsensical ideas and then discard them later…]

We could identify our current entry signal as a setup and not an entry. Say we identify XLF (still financials) as a buy… now we watch XLF until the RSI (or MACD or [insert your favorite technical indicator]) signals oversold — an entry condition to going long. This may help by filtering out more potential trades by waiting until the situation is “just right”. Trend followers would probably choose a breakout instead of an oscillator like RSI.

I’m sure we can come up with some additional ideas (comments can be posted for your additional thoughts) that would be just as pertienent if not more valuable than what I threw out there… But the point is that we should think a bit longer about what could be a potential high hurdle (a > 70% success rate required to be successful) and at least explore our choices.

I look forward to hearing your perspectives on this topic as well…? (feel free to use trackback if you have something more than a short comment.)