November 29, 2007 at 8:31 am | | Comments 3

Consider Risk First, Then Reward

Anytime I am eyeing a trade to make, the first thing I consider is what is my risk in case I’m stopped out. Theoretically I might not be able to foresee all that could happen to a stock, but barring a major news event or gap in the stock, I want to first determine at which point I’ll need to exit the position. Only after this step do I take a look at the positive potential for the trade and then move towards a decision for an entry.

A major difference between amateur traders and professionals is the fact that amateurs consider the potential reward first and then may look at their risk, while professionals consider their risk first and then look at the potential reward. This is a big deal!

Keep Your Head On Straight

The market carries a lot of allure and it can entice you into making larger or bolder trades when all you look at is the reward side if it pans out. However, surviving the trading game and sticking around long enough to make a living at it will require that your risk be quantified before anything else. Even with those home-run types of plays you might feel very strongly about, you still need to determine at which point you’ll bail out of the trade and cut your loss in the event that you’re wrong.

Consider the earnings play by the amateur trader trying to make a quick, easy buck on a favorable gap from the announcement. This play is attempted all the time, but the truth of the matter is that while the odds are high that a gap will come, the direction and size of it simply cannot be determined. This leaves the trader hoping to hit it big but very uncertain as to their exit plan if the stock moves against them.

Trading Like A Pro

Professional traders operate in a completely different manner. What appears to be a good trading opportunity is examined before the entry is made. This closer look may not take a long time, but it will reveal to the professional key information that will make up his mind on whether or not to take the trade. Determining an adverse exit level will allow him to define his risk, size his position accordingly, and then decide if a favorable move will pay him a multiple amount of what he’s putting at risk.

This principle is at the heart of profitable trading, because we are going to have our losing trades, sometimes frequently. Ensuring that those losses are contained will make them very easy to overcome with winners that we will find, but a methodical approach which begins with a look at the risk is where it all begins.

Jeff White
President, The Stock Bandit, Inc.
Swing Trading & Day Trading Service

[tags]Stock Market, Day Trading, Stock Trading, Investing, Swing Trading[/tags]

RSSComments: 2  |  Post a Comment  |  Trackback URL

  1. Dear Jeff,

    In order to set the risk vs reward in stock option, what is the stop loss setting in options which we understand the the movement of this options is wider compare with stock.

    Especially if the stock has very high volatility such as GOOG or CROX.

    Thanks for sharing

  2. Hey Handy,

    Thanks for your comment. Yes, options are leveraged so they move more on a percentage basis than their underlying stocks. However, I think the trading strategy should be determined by the moves in the underlying stock. So the stops may be wider for the options, but I think the exit criteria should be based on the stock having broken support or whatever technical criteria you specify.

    An example would be XYZ with a $25 buy point and a $24 stop. If you don’t want to buy the shares, buy call options instead. Exit the call options when XYZ breaks $24 to the downside. That might mean a larger percentage loss on the calls vs. the shares, but the upside is also much larger for the trades which do work.

    Hope this helps!


Trackbacks: 1  |  Trackback URL

  1. From World Series Series, Part 2 - Have a Backup | on Oct 23, 2008

Sorry, comments for this entry are closed at this time.