Is the Risk/Reward Ratio in Your Favor when Investing?

This post is more for traders, but can also apply to investors. A common misconception is that trading is the same thing as day trading. These two are different concepts. “Trading” just means that you have no directional bias (bull or bear), whereas investors tend to have a bullish bias.

Now that I cleared that up, let’s get straight into the post. In this post, I’m going to talk about the ultimate investment (or trading, whatever you want to call it) strategy. No, this is not a model that can accurately predict the market’s movement 100% of the times, because nothing can do that. No, this is not some abstruse fundamentally or technical based strategy.

This is very, very simple. The ultimate strategy is made up of two questions:

• What is the risk:reward ratio?
• If the worst case scenario happens (risk plays out), what is my margin of safety?

Why These Questions are Important

These days, there is just too much uncertainty in the markets. Too many false breakouts that make chart patterns less useful. This year (2013) many seasoned traders and investors have become confused. One day it looks like the market is ready for a bearish breakout, then the next day stocks soar.

In other markets, things are even more confusing. Since gold and silver have fallen for more than half a year (silver by 40% and gold by 35%), these markets are long overdue for a massive rally. Instead, they’re languishing at the bottom, moving sideways.

In tough times like these, how does one hold firm in his bullish (or bearish) market outlook? How does one stay resolute?

By looking at the facts: is the risk-reward ratio in my favor?
How to Define the Risk-Reward Ratio

The “risk” is where you know that the market will have massive support, meaning that the market will not break any lower.

Let’s assume that you’re bullish on Stock A, which is currently at $50 a share. Previously, Stock A had been trading at $80, and you know that Stock A’s long term bull market is not over yet.

If you know that a lot of people will buy if Stock A sinks to $40 a share, then your risk is $10 on the downside ($50 – $40 = $10).

On the flip side of things, Stock A’s previous all time high was $80 a share. Since this long term bull market is not over yet, the MINIMUM that the stock will go to is $80. Thus, your reward is $30 ($80 – $50 = $30).

To conclude, your risk:reward ratio is 1:3.

In other words, the way to define this ratio is simple. What is the maximimum amount of money you can lose, defined by where the massive buyers are willing to come in, and what is the minimum amount of money you can make, defined by where the resistance is (e.g. previous all-time high). (We use maximum and minimum just to stay on the safe side of things.)

Based upon my own experience, any risk:reward ratio at or above 1:3 is acceptable. 1:4 is good, and 1:5 is insanely awesome (and rare).

The Importance of a Margin of Safety

As Intel CEO Andy Grove once said, “the pessimists survive”. In the markets, we always need to prepare for the worst case scenario, which is where our margin of safety comes into play. Even if our market outlook is dead wrong, can we still exit our positions without a loss?

The margin of safety is always based upon your historical analysis and the context of your current market stage. By looking back at history, you can see that every time X happens, Y must follow. That “Y” is your margin of safety.

Here’s an example. Based upon my own research, I’ve found that after every 9 month decline that has had no meaningful rally, a bullish rally is long overdue. Even if the market crashes further, the market will still make a 50% Fibonacci Retracement rebound. Thus, if I buy into a market after it has declined for 9 straight months, I am safe. Even if the market crashes further, it will still bounce back to the price I bought at, allowing me to exit my position without a loss.