After an entry the risk/reward ratio quantifies a trades potential for loss size versus the size of possible profits. When backtesting signals the average size of all the losing trades in a system compared to the average size of all the gains gives you the system’s risk/reward ratio based on historical price action.
For discretionary traders, looking at your stop loss versus your profit target for any trade can tell you whether the risk is worth taking the risk on a trade. Most of the time a trade is only viable if there is at least a 1:2 or 1:3 risk to reward ratio based on your trade management plan. The reward should always be a multiple of the stop loss for a good probability of being profitable over the long term.
The higher your reward could potentially be versus your risk, the less your winning percentage has to be to make money. The lower the needed winning percentage the higher the probability of profitability for the trader or system.
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Your risk is established by the location of your stop loss on the price action on the chart. A stop loss should be set at the level that will show you that your trade is not going to work out and it is time to exit while a loss is still small.
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Your profit target on entry is the price level you believe that price has a high probability to go if the trade is a winner based on the chart pattern of historical price action. Your maximum reward is where the most potential profit could be achieved and can be set to establish the reward in your ratio.
You can maximize the potential for capturing a big trend by being flexible and leaving your upside uncapped by using a trailing stop to take you out of a winning trade and only exiting when price reverses. A trailing stop can create bigger winning trades and maximum rewards by risking open profits to let your winning trades run. The drawback of using a trailing stop versus a profit target is you will never get out at the top.
To psychologically create a great risk to reward ratio you need to be very patient with winning trades and give them enough room and opportunity to play out for the most benefit. While at the same time having no patience for losing trades and exit the moment you are proven wrong based on price action hitting your stop loss.
If you buy 100 shares of a stock at $100 for a $10,000 position size and your stop loss is at $97 and your profit target is at $109 here are your risk reward dynamics.
- Your risk is $300 if your stop loss is triggered.
- Your reward is $900 if your profit target is reached.
- You risk/reward ratio is 1/3.
- You are risking $300 to make $900.
- With a 1/3 risk to reward ratio you only need a 25% win rate to break even.
- To achieve profitability you have to either tighten you stop losses or make you winners bigger when possible.
-$300
-$300
-$300
+$900
Even
Your risk is how much losing trades cost you, your reward is how much winning trades pay you.
Risk Vs Reward Chart
Creating good risk/reward ratios with high probability entries through stop losses & letting winners run is the core of all profitable trading.
For a deeper dive into risk management for traders check out my bookThe Ultimate Trading Risk Management Guide.
Single country funds are highly risky especially those related to emerging markets. Holding these funds for the long-term defined as five years or more requires strong conviction and patience and there is no guarantee that the bet would be a winner. I recently came across an article that discussed the risks and benefits of investing in single country funds. From the article:
24: Risks And Rewards Credit Cards
Scottish American Investment Company was founded by William Menzies in the 1870s, after a series of visits to the US left him impressed by the wealth and opportunities the rapidly industrialising country presented. Being the most exciting emerging market of its day, America, it was hoped, would provide strong returns for investors in the UK.
Similarly, today, many investors are drawn to emerging markets undergoing their own economic transformations, typically by investing through an actively managed fund or investment trust. While many investors may opt to access such economies through broadly spread emerging market or regional funds or trusts, picking a single-country focused investment has become increasingly popular.
‘There has been a sudden rise in the popularity of single-country emerging market funds,’ notes Chady Jouni, senior portfolio manager at Barclays Wealth Management.
It’s not hard to see why. While emerging markets as a whole have done well in recent years, some individual countries have raced ahead of their peers. The Investment Association’s emerging markets sector returned 46.8 per cent over the past five years, while Asia Pacific excluding Japan returned 70.3 per cent. By contrast, funds in the China/Greater China sector more than doubled in value on average over that timeframe. It’s no surprise that China outperformed its peers in both the emerging market and Asia Pacific sectors, but it does underline an important point: going after a broader grouping of countries can act as a drag on returns.
Source: Investing in a country-specific fund – the risks and rewards by Tom Bailey, Money Observer
The following chart shows the performance of country ETFs for China, India, Brazil and Russia over the past 5 years:
Click to enlarge
ETFs shown:
- iShares MSCI China ETF(MCHI)
- iShares S&P India Nifty 50 Index Fund (INDY)
- VanEck Vectors Russia ETF (RSX)
- iShares MSCI Brazil ETF (EWZ)
Source: Yahoo Finance
China and India have been the biggest success in terms of returns over the time period while Russia and Brazil were poor performers with a decline of about 20%. This shows that an investor that believed in the growth of Russia and Brazil and invested in an ETF and held on for the past 5 years, lost money. The bet did not turn out as expected as Russia was hit hard with collapse in oil prices and Brazil plunged into chaos with a massive fraud at Petrobras(PBR)and other political instability issues.
So they key takeaways for investors is that investing in single country funds is not for the faint hearted. Emerging countries can easily go from top performing to worse performing. So diversify and do not bet too much of a portfolio on one country.
Disclosure: Long PBR
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