A long-term trend which may have developed over several months may look huge on a price chart. The price in an individual stock may have appreciated 100% - maybe more. And that's great. A lot of traders trumpet their own trades in this manner. But that's not what I'm interested in.
Take for example a stock that moves up 100% over the course of a year. The entry was at $50 and went up to $100. In that period where will have been some price movements against that main trend - some bigger than others. So, to stay in a trade for that length of time, it is more than likely that the initial stop and exit parameters are quite loose, to allow for this price fluctuation or 'noise'. The initial stop was placed at $40.
Next, look at a stock which gave an entry signal at $10 and moved up 30% in a few weeks, before generating an exit signal at $13. Nowhere near as spectacular, I hear you say. But then I tell you that the initial stop was placed only 50c away from entry.
So, which is the better trade - the one where price moved 100%, or the one that moved only 30%? I'll let you do the maths.
Reward / Risk (Situation 1) = $50 / $10 = 5
ReplyDeleteReward / Risk (Situation 2) = $3 / $0.50 = 6
Situation 2, since the return as a percentage of equal risk taken is higher!
Correct - the problem is that a lot of traders don't look at or express their returns in that manner. They will simply say "I picked a stock that went up 100%" but to me that's only part of the story. As in the example on the post, the smaller price resulted in a bigger profit (in terms of R). Makes you wonder if they are more interested in their stock picking capabilities or making money...
ReplyDeleteI did receive the following comment from somebody named Tetra this morning, which has mysteriously disappeared! Anyway, he said the following:
ReplyDelete"Agreed completely. This sizing methode (imo) has a twin rule which states that no more than a fixed percentage of available equity can be placed (engaged) on any single trade. A stock which's made a very tight consolidation presents a nice opportunity as R will be a small percent of the stocks price. But as a result, you might freeze a non negligible portion of capital on a trade. Any stock can gap countertrend, which, unlikely as it seems when trading with the trend, still can happen. Risk of ruin not being an option (and "unlikely" not being good enough), i never engage more than 20% of equity on a trade."