How to become a good Stock Trader –Article 2 – Risk-Reward Ratio

The major problem which a trader faces problem is to follow a disciplined approach. In all my previous posts i have been mentioning about discipline,strategy though i rarely get time to put in more details on the trading part of analysis as well as people are more interested in stock specific recommendations or rather a technical view on the index.

 

So will try to start a new series of articles which would be based on topics which would help me and lot of traders

Some days back i had posted a similar article which could be a good read before you start on the current article.

http://www.nooreshtech.co.in/2010/09/how-to-become-a-good-stock-trader-2.html 

The first terminology which is the basis of doing trading. Apart from being able to find right trades and right analysis one needs to follow a good discipline to make money.

What is more surprising is you need to have only a 50-65% accuracy ratio provided one uses a good risk reward.

The three parameters to know before calculating a Risk-Reward Ratio are

1) Current  Market Price/Buying Price

2) Target Price

3) Stoploss

Risk = Buying Price – Stoploss

Reward = Target price – buying price. 

Risk-Reward Ratio = Target Price / Risk

So lets see an example how does one calculate the Risk-Reward Ratio before taking a trade. Once that is done all one needs to do is execute mechanically.

1) K S Oils   - Click here to go to the link

So let us see what the 3 parameters were

1) 54.3

2) 60 /66

3) 52

 

Now let us see how the calculations take place.

Risk = 2.5

Reward = 5.7 / 11.5

 

Risk-Reward Ratio = 5.7/2.5 = 2.3 or 11.5/2.5 = 4.6

So Risk-Reward Ratio is roughly 1 : 2.3  or if 2nd tgt is done it would be 1:4.6.

So calculation part is understood now we look into the execution part.

The execution rules are as below.  

1) Exit when 1st target comes. ( am not considering 2nd tgt also)

2) Exit when Stoploss Hits.

Once the risk-reward and system is known let us see what would happen in a real life scenario where you do many trades and you right as well as wrong.

Suppose if i take 4 such trades in which two go right and two go wrong with a risk reward of roughly 1: 2.5 ( ideal for quick traders)

Consider following criteria for simplicity and you have bought 1000 shares.

Buy Price = 100

Target Price = 125 and 140

Stoploss = 90

 

1) Profit = 25000

2) Loss = 10000

3) Loss = 10000

4) Profit = 25000

Net Profit = 30000

 

So from the above thing it is clear that 4 trades were taken so money deployed is 4 lakh rupees. The net gain is 30000 rupees which is still a clean 7.5% on the capital deployed.

Isn’t this an awesome return if you can get trades with a risk-reward ratio of just 1:2.5.

But reading through this you did not realize that you were right only 50% of the time in predicting a good stock move and you still made a clean RETURN !

The point is clear that making Money in trading can be much more easier if you would apply simple risk management techniques with DISCIPLINE:)  and you need to be right only 50-70% of the time to have a consistent performance. ( But the best way to sell Advisory Services is to say 95-100 % accuracy rate !!! )

For the record i am very happy if i can achieve beyond 75% as my general accuracy rate is 60-75% only which still can give consistent returns.

 

The only time to deploy over leverage is special scenarios where suddenly the risk reward ratio is excellent. The last time advised leverage was at 16000-16400 stoploss of 15900. Target Price 17100/18400. This gave me a risk-reward 1:3 to 1:7 ! which is super !

 

For the last few years i have been trying to deploy the above principles as the base of my trading advisory services and disciplined people have been consistently making money.

Also learning through the process of trading with the basic principles and how to mechanize the whole process of trading without emotional attachment

Next week we may look into how to take into time as a parameter in trading decisions.

 

P.S: By the way when K S Oils dropped from 54-55 to 52-53 in the day i did get many queries like WHAT TO DO? STOCK IS DROPPING ? Will this move like CHAMBAL FERTILIZERS?

The whole point is you need to size your position in a manner that a 5% stoploss does not bother you and you dont get greedy before the 10-15% target.

Will try to cover Risk Management and Position Sizing in the next post when i get time.

I believe the above article was as boring as the one before as this article is of no material use and no gains or losses can be made but if you still liked it and would want many of your other friends to read and get bored please take the liberty to do so through yahoo, facebook, orkut and other communication or spam mediums

 

Regards,

Nooresh

Analyse India

mail me on noorrock2002@gmail.com if you have some inputs or use the comments section.

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4. Hexaware – Risk-Reward Entry Point with RSI positive divergences
5. Nifty – A risk-reward buy Opportunity at 5950-5970

Tagged as: How to become a good Stock Trader, Risk-Reward Ratio, Successful Trader