The Hindu Business Line : Concept of risk-reward ratio

The nature of the recovery in price is not as vital as is commonly assumed. Being on the right side of market is more important than being right about the market. Investors should try to concentrate on correctly identifying the direction of the market movement.

I have a few doubts and need your advice on arriving at stop-loss methodologies. It would be helpful if you suggest some easy ways to identify stop-loss levels. Please explain if the stop-loss level would vary depending upon the time frame in which a person trades. How to identify if an upward move is a short recovery within a long-term bearish phase or is part of a new bullish trend? — C. Rajee

You have asked an important question; unfortunately, the concept of stop-loss and the related aspects raised by you is so vast and significant that it cannot be condensed to a few columns of a newspaper. As far as your first question is concerned, the stop-loss would vary depending upon the time frame in which an investor trades. Though the methodology to arrive at the stop-loss may be the same across different time frames, the stop-loss level is bound to vary.

Though the gamut of concepts relating to stop-loss cannot be addressed, we would like to stress the importance of the key concept of "risk-reward' ratio in this context. The most important criteria for executing an investment decision should be the risk-reward ratio.

The risk-reward ratio can be calculated once the proposed entry, exit and stop-loss levels are identified. The `risk' in a trade would be the loss that an investor has to bear if the stop-loss gets triggered.

This would be the difference between the entry price and stop-loss level. Similarly, the `reward' would be the difference between the proposed exit price and the entry price.

Generally, a risk-reward ratio of 1:2 (for one rupee of risk, investors should typically expect a return of two rupees) is considered as the minimum requirement for initiating a trade. Seasoned traders may settle for a risk-reward ratio of 1:1 or lower if the chances of the trade turning out to be a winner are high. Investors need to have the discipline to control emotions and refrain from taking investment positions where either the risk-reward ratio is unacceptable or there is no clarity about the entry, exit or stop-loss levels.

A compulsive trader who has the urge to be in a trade at any point in time would have to contend with steady erosion in the personal net worth.

Studies indicate that more than 90 per cent of traders lose money, 6-7 per cent manage to break even and only 2-3 per cent are successful in the longer run.

Money management and discipline are key factors that would help an investor to get into the 2-3 per cent bracket.

A stop-loss level would be dependent on the interplay of a few variables. Beginners, especially those who do not have access to resources, may settle for a flat percentage-based stop-loss. We would not, however, recommend such an approach, as it is irrational. A simple rule of thumb for arriving at a stop-loss would be to identify price levels at which a contra-signal would be triggered.

That is, for long positions, identify a price level below which a sell signal would be generated.

A few ticks above or below such contrary trigger levels would be an appropriate point to have the stop-loss. The other approach could be to identify strong support or resistance levels and have the stop-loss a few ticks above or below that level.

If the identified stop-loss level is too wide leading to a risk reward ratio that is below 1:2, investors may wait for the price to get closer to the stop-loss level so that this ratio gets skewed in favour of reward, as the risk element gets minimised.

As far as your last question is concerned, we would like to emphasise that investors/traders need not attach too much importance to the nature of the recovery in price.

It would be immaterial for a trader whether an upward move is a part of a new uptrend or just a correction to an earlier fall.

In either case, the expected direction of price movement is up; logically, long positions should be taken.

Investors should try to concentrate on correctly identifying the direction of the market movement. Being on the right side of market is more important than being right about the market.

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