Satuki @ Home

For traders like you and me, stocks are nothing but electronic symbols. I only use volatility and liquidity to choose what stocks I trade. I will talk about why we need volatility and liquidity in the future. They are very easy to understand. The focus of today’s topic is Probability and Risk-Reward-Ratio (R-R-R). These two elements are a very crucial part of our trading career.

First let me use a simple game to illustrate what probability is in trading. We all know that the probability of an outcome of flipping a coin is 50%. If you bet a dollar on head and I bet a dollar on tail. No matter how many times we play the game, we would break even in the end since the probability is 50%. Neither of us has an edge over the other. However, if you somehow increase your probability to 51%, you would beat me in the end. That is how casinos make money. Most people who go to casinos lose eventually. The house is always a winner since the odds are in the house’s favor. That is probability.

Now let’s change the rules of the game. If you win, you make 2 dollars and if you lose, you lose 1 dollar. In other words, you risk a dollar to make 2 dollars. As for me, the rules are still the same. I risk one dollar to make one dollar. Your R-R-R becomes 1:2. Mine is 1:1. Probability is still 50%. It is not hard to see you will take all my money quickly. That is risk-reward-ratio.

Trading is not a zero-sum game since you will have to pay commissions to your broker. Even if your probability is 50% and R-R-R is 1:1, you’d still lose. So trading is a little bit harder than flipping a coin. Now it is quite obvious what we need to improve here. If you can prove that the accuracy of your system is over 55 percent no matter how market behaves and your R-R-R is 1:1, then what a brain surgeon makes would seem like peanuts to you. It seems easy to trade with an R-R-R of 1:1 since you really do not have to wait for a stock to move that much. However, the accuracy of your system is what you need to work on and it is extremely hard.

Another way is to put up with your poor accuracy and increase your R-R-R. As you can see from the day I traded CMA, my accuracy was pathetically low. There were 4 trades. Only one made it. However, I still made some good money (percentage wise 3%). If I had traded 50K for each position, I would have been up $1500 that day. Of course, most of your positions will fail since it is hard for them to move such a large distance. This methdology will test if you have mastered the time and battle proven strategy, which is “cut your losers and let your winners run”. Trust me. Holding onto your winners is much harder than cutting your losers.