Risk : Reward Anatomy
Inmortal Technique
INTRODUCTION
When I started trading I had a small notebook –very messy- where I took note of all the trades I was doing, noted the balances, the trade details, entry points, exit points, stop loss, etc. You could say it was a trading journal.
After a while, I started adding small additional notes next to the trades I was journaling, some examples: “I’ve taken an emotional decision exiting this trade so early”, “I’ve followed my plan with discipline”, “I think I didn’t set the SL well enough”, etc…
Slowly I started to give those “small notes” more and more importance and developing them more to the point that I decided to put those notes in a separate notebook.
This article that you’re about to read is just a reflection about that notebook. When I wrote it I did it with the single purpose of helping myself get better at trading and never thought about publishing it.
What is this article about?
I don’t know how many trades I’ve done throughout my career as a trader but I’ve spent enough time inside the market to know every corner of a trading setup. Originally, a trading setup has 3 parts: Entry point, take profit and stop loss.
I wanted to dive in a bit more and I have dissected the trading setup into 8 fundamental parts. Entry, Stop loss, The red zone, Break even, No man’s land, Minimum Take Profit Zone, Secure Take Profit Zone and Optimum Take Profit Zone.
Depending on which zone of the setup the price is at, we’ll have difference emotional reactions. Making an emotional decision in the wrong zone of the setup could lead to capital loss and to a potential chain of mistakes.
Depending in which zone of the setup the price is at, we could have profits or losses in that trade. But… How do we make sure we maintain profitability long term? In what zone of the setup do we ensure long-term consistency?
In this article I delve deep into these 6 “new” zones of a trading setup, give insight into what zone we’re most likely to make mistakes, what zone we should take profit to ensure long-term profitability and in what zones emotions are more intense.
I hope you’ll enjoy it, here we go.
Scheme of a Risk : Reward setup
Anatomy of a Risk : Reward configuration. THE RED ZONE
Starting from the bottom, the red zone: situated between the entry point and the stop loss. This is likely the zone where most mistakes are made, at least from my experience. Here is where emotions are most intense, the price is below your entry point and you are at a loss but your idea hasn’t been invalidated yet. In this zone It’s common this line of thoughts: “I don’t want to lose more, I’ll get out now; I’m sure it’s going to hit SL”. The point here is that our idea or setup isn’t invalidated in the red zone but at the stop loss. In the red zone we don’t make decisions, If you do you’re breaking your plan and making an emotional decision that leads to more wrong decisions like entering a new trade as a revenge or with the hopes of recovering the losses. Has exiting the trade in the middle of the red zone ever worked out for you? Yes, maybe somethime, but the life of this “strategy” is too short, If you don’t follow your plan and you cut your trades before they hit stop loss –which is the invalidation point that you yourself decided- you’ll have consistency problems in the long term.
Trading is a long-term game, It’s better to have discipline and always wait for the price to hit the stop loss that flirting with exiting in the red zone and triggering a chain of bad decisions.
The red zone must be an “Only looking” zone, let the price develop. Avoid making decisions here and you’ll avoid a lot of potential mistakes.
Anatomy of a Risk : Reward configuration. STOP LOSS
When you’re planning a trade ask yourself: Where would I be wrong? Where would my idea be invalidated? That’s where you must set your Stop loss.
You have to set the SL where your idea is invalidated and adapt the size of your position to it.
The size of the position has to be adjusted to the SL and not the other way around, meaning; first we set the SL and then we calculate the size the position will have, this way we’ll make sure we always risk the same quantity.
A really common mistake is to always use a random position size and set the SL arbitrarily.
For example: You enter on a trade with too much size and you see yourself forced to set the SL in a random point so as to not lose too much capital. The big problem here is that the SL isn’t set at the point where your idea gets invalidated and this can lead to your idea to be “correct” but the trade might result in a loss of capital because the SL wasn’t set up correctly.
Anatomy of a Risk : Reward configuration. BREAK EVEN
You entered a trade, the price fluctuated, it came back to your entry point and you decided to exit there. Theoretically, without gains or losses. Why theoretically? Here is where commissions gain importance. If you exited in the same point that you entered, it’s likely that you’ll have to note a small loss in capital, the size of the loss will be defined by the size of your position.
For example: If we’re trading an active that in that moment has low volatility and we exit and enter constantly our positions, even if it’s in breakeven; the result will be a loss of capital. Commissions have weight in this game and we have to be absolutely clear about this. Break even doesn’t always mean zero losses.
When we enter in a trade, we choose two important zones, one is the zone where our idea is invalidated: the SL, and the other is where we’d take profit: the TP.
If we’ve already chosen the two exit points before entering a trade, either with profits or losses; why change your opinion in the middle of the trade and exiting at Break Even?
Break Even is similar to the red zone. For me it’s a zone where I try to not make decisions, the big difference between the BE and the red zone is that here there’s no loss of capital (or it’s minimal). The reason I avoid the BE is simple: it can lead into a potential chain of mistakes.
Then when is it okay to use the BE? When is it NOT an emotional reaction?
If you’re going to exit in BE make sure it’s because of a technical reason and not an emotional decision. Let’s set an example: we enter a trade, the price advances to our favor and the minimums start to get higher and at some point it falls abruptly to our entry point. If the price has broken the market structure or it has closed below an important level, the logical thing would be to use the BE and wait for another opportunity outside the market. What I’m trying to convey is that the BE should only be used when the technical analysis shows us that there is a strong possibility that the price will not continue to move in our favour. I personally think that the BE requires a lot of discipline and abusing it long-term could be detrimental.
In conclusion: the BE is useful but it’s use should be occasional.
Anatomy of a Risk : Reward configuration. NO MAN’S LAND
Situated between the entry point and the profit zone 1R, similar to the red zone and the break even in that it’s a zone with the potential of triggering more mistakes. The big difference with these ones is that exiting here will generate gains. The big problem becomes visible in the long run. If a trader gets used to exiting his trades in this zone he’ll be exiting too soon and will be unable to be profitable in the long term. Let’s assume that you’ve got discipline and you tend to risk the same quantity (1R) in each trade. If you get used to closing your trades in this “no man’s land” zone before reaching the take profit zone (1R) –that we’ll talk about in the next section- the gains you make will be smaller than the quantity that you risk in each trade, meaning that long-term your losses will be bigger than your gains. That’s the reason I avoid at all costs exiting a trade in this zone.
Anatomy of a Risk : Reward configuration. 1R — MTPZ
Minimum Take Profit Zone. We’re entering the take profit zone, from here onwards we can start paying ourselves. If we close the operation completely in 1R we’d gain the same amount that we risked.
Is it profitable long-term?
It depends on the winratio. If we always exit our trades (completely) on 1R and we have a 50% winratio (we win 50% and lose 50% of the trades) we’d be in a “draw”, without gains or losses of capital. To make exiting on 1R a profitable strategy we’d need at least a 60% winratio.
It’s hard to be profitable if you cut your gains that soon, logically we have to let the gains run more than the losses.
In summary: We can completely close our trades on 1R on limited occasions but it must not become a habit if we want to be profitable long-term.
Here’s where the game of taking partial profits comes into play. If we are impatient we can take SOME profits at the 1R zone, for example; a 20% or 50% of the total position. This will ensure some profits and will reduce the risk.
Here are some examples:
If you take the 50% of the operation on 1R, you’ll make a realized profit of 0.5R and since you’ve reduced the size of your position to half, your potential loss if the price touches the SL is -0.5R. A “technical break even” if you take into account the realized profits.
If you take the 50% of the operation on 2R you will get a realized profit of 1R, this way you’re in a “riskless” trade. If in addition you rise the SL to the BE you’d have 1R assured.
As a general idea: 1R is a good zone to secure some profit or to reduce risk, you can cut 20%, 30%, 40%, 50% of your position, but you must avoid closing completely your trades here.
The higher we take profits the less winratio we’ll need to be profitable.
Anatomy of a Risk : Reward configuration. 2R — STPZ
Secure Take Profit Zone. Here we get closer to long-term consistency, If we close our trades completely here we’ll win twice the amount we risk in each trade and that means that we’ll “only” need a 40% winratio to maintain ourselves profitable.
Anatomy of a Risk : Reward configuration. 3R — OTPZ
Optimum Take Profit Zone. 3:1 is one of the best risk : reward setups and one of the most used. If you close your operations completely here, you’ll gain a profit thrice as big as the amount you risked. An example: Imagine a new trading account, you win the first trade with a 3:1 setup (3R), if you were to lose the next three trades the account would stay the same as in the beginning. It’s here where the magic of being disciplined with the risk management manifests itself. It’s not necessary to win every time to be a successful trader, in fact; if you always use 3:1 setups you’ll only need a 30% winratio to be profitable. Let’s illustrate this with numbers: imagine you take 1000 trades, always with a 3:1 configuration. In this case you could win 300 trades and lose 700, you’d still be profitable, and you’d have a trading account with profit.
Trading doesn’t understand about absolutes. it’s not about being right or wrong, It’s about risk management, probabilities, consistency and discipline.
Anatomy of a Risk : Reward configuration. +R
Closing trades with 3R or more R’s makes us very profitable traders and makes us able to get over long losing streaks –that we’ll definitely have throughout our career as traders-. With 5:1 setups (winning 5 times the amount you risked) we’ll only need a 20% winratio to maintain ourselves profitable. That means that if you’ve got the technique and discipline to always get 5:1 setups, you’ll only need to be right 20% of the time. This opens the door to another personal debate: What’s going to be my style of trading? High probability setups but with few R’s (1:2 setups) or setups with low probability and a lot of R’s (4:1 setups or higher). Choose the style that best adapts to your abilities. Each trader is good at a style but to discover your style you’ll need to keep constant journal your trades so you can study it and find out your strengths and weaknesses as a trader.
How to get +3R trades regularly? TIMING AND PATIENCE
I think the key points to get 3R setups or higher are:
Patience; to let profits run, and Timing; to get good entry points to the market with little margin for error. The more R’s we try to win in a setup the less margin we’ll have to make mistakes, our stop loss will be shorter, meaning; we’ll be closer to our point of invalidation.
In a long-term trade (HTF) we’ll need -timing since we won’t need a lot of precision for our entry but we’ll need +patience because the final take profit will be further and most likely it’ll take weeks or months to reach it.
In a short-term trade (LTF) we’ll need less patience since it will take less time to reach the TP but we’ll need a lot more precision and a great timing to make a good entry into the market and not be “stopped” before the movement we’re waiting for happens.
In conclusion, depending on the time frame in which our configuration was planned we’ll need more or less from one ability or the other. It’s dynamic.
RISK : REWARD & WINRATIO (TABLE)
Memorize the following image or print it and put it next to your screen. This image shows us that trading isn’t a competition about always hitting the mark but a marathon where the important thing is to let the profits run and to cut your losses early.
You don’t need to be right all the time to be a successful trader. Remember this.
LAST WORDS
I hope you’ve found this article helpful and that you’ve learnt something from it. Remember that trading is a career in which the learning process never ends.
Any time you make a mistake take the time to analyze and learn from them. From my point of view that’s the only way to improve as a trader.
And finally;
Writing this article has taken me a lot of hours of work and I’ve published it entirely free. I consider sharing knowledge is the best way to move forward, so; Share it!
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NOTES
1R — The R’s is a really useful way to understand risk : reward and measure our profits and losses in a setup. 1R is the amount we risk in a trade if the SL is hit, we would write it as -1R. If we win 3R it means that we’re gaining 3 times the amount we risked. If we win 10R it means we win 10 times the amount we risked.
Imagine that you’ve got an account with 1000$ and you decide that you’re going to risk only 1% (10$) of the account on each trade, that would mean that if the stop loss is hit you’d lose 10$, in this case 1R = 10$. If you lost a setup you’d write down -1R (10$). If you were to win an 8R setup you’d write down +8R (80$).
I want to thank my good friend Deyvid Petrov for helping me translate this article.
Inmortal Technique
FIN
