Using Risk to Reward Ratios and Finding the Appropriate Trading Philosophy for Your Goals
This article is going to explore some basic concepts of risk to reward and some of the fundamental trading methodologies behind trading options, stocks, credit spreads, etc.
In all of the following theories, the underlying concept that lays the foundation for the success or failure of each is risk to reward.
The risk to reward ratio, simply defined, is a process of comparing the potential risks of an investment or trade to the potential reward for the same investment or trade.
Think about what the risk to reward ratio is for each of the following trading theories as we go through them one by one.
The theory of Buy and Hold Some traders and instructional or educational trading companies out there say that "buy and hold" is the way to trade only.
What buy and hold basically means is that an investor or trader will buy a stock, hold onto it for three to five years (maybe much longer), and hopefully make a little amount of money on it.
The buy and hold system worked for many, many years, but once the Internet came into play, and you didn't need to call your broker to get charts or a stock quote, the entire game changed.
The entire timeframe it takes for a trade to be conjured up and executed to when it's closed out has diminished from what once took days to literally seconds, so the traditional buy and hold methodology no longer works.
The truth about Dollar Cost Averaging "Dollar cost averaging" is another trading mechanism that is broken.
Dollar cost averaging is based upon the notion that every once in a while on your own schedule, you're going to take whatever money you have to invest and you're going to put it all into the same stock.
Over the long-run, this averages down the cost of the stock.
Here's an example of dollar cost averaging in a practical application.
Let's say a stock is trading at $50 per share and you're going to put $10,000 into the stock every single quarter, or every three months.
So the first month, you buy 200 shares of the $50 a share stock, an investment worth $10,000.
Whether the stock goes up or down during the next three months is anyone's guess.
But DCA says that come three months from now, you'll be buying another $10,000 worth of shares.
But what if the stock is down to $40 a share? Dollar cost averaging says to take your quarterly $10,000 and buy the stock at the lower price, because you're averaging your overall costs down for the long-term.
The danger is when that same stock goes down to $30 a share, $20 a share, or even more disturbing, down to $10 a share, and because you're dollar cost averaging, you continue to buy more shares even though the price isn't really in your favor.
So now you don't own this company's shares at $50; you own some at $50, some at $40, some at $30, some at $20, and some at $10, and you'll take the average cost and apply it to your gains.
The problem real traders see is that from the very first quarter, you're losing money on the investment by simply entering the trade at $50 and staying in it as the price slips.
The bottom line is that you're down and you're losing money.
So what trading principles can new option trader and investors trust? Let's borrow a principle from poker players: know when to fold them.
If you find yourself in a trade that's losing money, and you're down more than 8% on that stock, option, or Forex spread, fold your hand and get out.
Many traders get emotionally attached to a trade and will have a hard time pulling out.
But traders should be urged to take that money out of a losing trade, put it in cash in your broker account, and watch the trade.
You can always re-buy a stock or re-establish a trade, but you will never sell a stock at a higher price than what the market is willing to pay.
For example, maybe your trade that you were so sure of is down 10%, so you got out.
But as the days and maybe even weeks pass, you notice that it stays at around that price.
To your delight, the price starts to head back up.
Now you can reconsider getting back into the trade.
Conversely, under no circumstances should a trader ever participate in a stock, option, or investment that's losing value.
In all of the following theories, the underlying concept that lays the foundation for the success or failure of each is risk to reward.
The risk to reward ratio, simply defined, is a process of comparing the potential risks of an investment or trade to the potential reward for the same investment or trade.
Think about what the risk to reward ratio is for each of the following trading theories as we go through them one by one.
The theory of Buy and Hold Some traders and instructional or educational trading companies out there say that "buy and hold" is the way to trade only.
What buy and hold basically means is that an investor or trader will buy a stock, hold onto it for three to five years (maybe much longer), and hopefully make a little amount of money on it.
The buy and hold system worked for many, many years, but once the Internet came into play, and you didn't need to call your broker to get charts or a stock quote, the entire game changed.
The entire timeframe it takes for a trade to be conjured up and executed to when it's closed out has diminished from what once took days to literally seconds, so the traditional buy and hold methodology no longer works.
The truth about Dollar Cost Averaging "Dollar cost averaging" is another trading mechanism that is broken.
Dollar cost averaging is based upon the notion that every once in a while on your own schedule, you're going to take whatever money you have to invest and you're going to put it all into the same stock.
Over the long-run, this averages down the cost of the stock.
Here's an example of dollar cost averaging in a practical application.
Let's say a stock is trading at $50 per share and you're going to put $10,000 into the stock every single quarter, or every three months.
So the first month, you buy 200 shares of the $50 a share stock, an investment worth $10,000.
Whether the stock goes up or down during the next three months is anyone's guess.
But DCA says that come three months from now, you'll be buying another $10,000 worth of shares.
But what if the stock is down to $40 a share? Dollar cost averaging says to take your quarterly $10,000 and buy the stock at the lower price, because you're averaging your overall costs down for the long-term.
The danger is when that same stock goes down to $30 a share, $20 a share, or even more disturbing, down to $10 a share, and because you're dollar cost averaging, you continue to buy more shares even though the price isn't really in your favor.
So now you don't own this company's shares at $50; you own some at $50, some at $40, some at $30, some at $20, and some at $10, and you'll take the average cost and apply it to your gains.
The problem real traders see is that from the very first quarter, you're losing money on the investment by simply entering the trade at $50 and staying in it as the price slips.
The bottom line is that you're down and you're losing money.
So what trading principles can new option trader and investors trust? Let's borrow a principle from poker players: know when to fold them.
If you find yourself in a trade that's losing money, and you're down more than 8% on that stock, option, or Forex spread, fold your hand and get out.
Many traders get emotionally attached to a trade and will have a hard time pulling out.
But traders should be urged to take that money out of a losing trade, put it in cash in your broker account, and watch the trade.
You can always re-buy a stock or re-establish a trade, but you will never sell a stock at a higher price than what the market is willing to pay.
For example, maybe your trade that you were so sure of is down 10%, so you got out.
But as the days and maybe even weeks pass, you notice that it stays at around that price.
To your delight, the price starts to head back up.
Now you can reconsider getting back into the trade.
Conversely, under no circumstances should a trader ever participate in a stock, option, or investment that's losing value.
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