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--- In AAQuants@xxxxxxxxxxxxxxx, Bill Kearney <bill_k35_2000@xxxx>
wrote:
** Risk (vs) Reward Ratio
Formula **
______________________________________________________________________
______ I have received a few questions regarding Risk (vs) Reward
Ratio Formulas. I have used this Ratio in a few examples in the past.
Although Risk is something you have to judge for your self in as far
as your trading style . There are a few generally accepted ratio
formulas. This is hard to explain since it is part of a total money
management system, however if you allow me to give you some basic
back ground on portfolio management it will make more sense. The
first thing about money management you must understand is DEFENSE is
extremely important. For example a 25% loss would require a 34% gain
just to break even not counting trading cost. A 50% loss would
require a 100% gain just to break even again not counting trading
cost. A 80% loss would require a 400% gain just to break even, Ex:
$100 - 80 = 20 x
4 = 80 or expressed another 400% !!!!!!!!!!!!!! Take for example
the Baltimore Ravens XXXV Super Bowl Champions. The Ravens are an
excellent example they won the Super Bowl with DEFENSE. By the way
the Ravens are my home Team. I will begin with the simplest Risk
(vs) Reward Ratio Formula. / Risk (vs) Reward Ratio Formula. In order
to calculate risk you must look at Technical Analysis, & understand
stock pivot points, support & resistance levels as well as market
momentum. The next step is to establish a trading journal,& then a
list of potential of either buy or sell candidates. I call this my
watch list, I further divide it into categories Buy List, Sell List,
Put or Short List, Call or margin Buy List. So we now find a stock
that we believe is a good buy candidate { XYZ } & we look at its
sector & see that it is either in favor or should soon rotate into
favor. Next we look for a catalyst to move the stock, Earnings
Report, New contract awarded etc... We then look at
technicals such as Bollinger Bands, Money Flow ={ MFI }, ADX, MACD,
RSI. We now look at 52 week high, 52 week low, 5 day moving average,
20 day moving average, 50 day moving average, 100 day, 200 day moving
averages. We ideally want { XYZ } at or near its 52 week low, with
its 5 day moving average above its 20 day moving average. We want to
establish a Maximum loss on the trade that we are willing to accept.
We can either use a straight % such as 10% loss or use a support
level below our entry level as an exit price or even a % below the
stocks support Level such as 5% . Thats say we have decided to take
3% from our risk portfolio, 3% is mathematically the maximum amount
you can risk of your total capital in blackjack in order to stay in
the game. I personally go a bit further & Divide my capital into 2
separate portfolios. one is passive & one is actively managed. I
Typically put 70% in the passive portfolio which is a combination of
the S&P-500 & Short Term Treasuries. & 30% in
the active portfolio, this is the one that is actively traded. I
further take 10% of the active portfolio, which is 3% of the total
portfolio & allocate it for penny stocks. Thats say your total
capital for investing is $ 100,000.00 , you would allocate $
70,000.00 to your passive portfolio & $ 30,000.00 to your Active
portfolio. out of the $ 30,000.00 you take $ 3,000.00 for hyper
aggressive pennies. Now back to our { XYZ } stock, it has a price of
$ 20.00 & a 52 week high of $ 60.00 & a 52 week low of $ 15.00, The
Stock has a support at $ 20.00 & resistance at $ 27.00. We set a
target price of say $ 30.00 based on fundamental & technical analysis
+ economic climate & what we believe will be an up turn for the
company in the next few months based on a possible increase of demand
for { XYZ } product. Now for the basic formula our entry price is $
20.00, Stop loss at $ 15.00, which is the next support level we then
enter our target price of $ 30.00. So our max loss is $ 5.00 per
share not counting trading cost. Our max gain is $ 30.00. So 100
shares at $ 20.00 is $ 2,000.00, if we had to to sell it at $ 15.00 a
share, we would loose $ 5.00 a share or $ 500.00. If the stock goes
to $ 30.00 a share, we would sell it & have a profit of $ 10.00 a
share or $ 1,000 . So here we are looking at a 2 to 1 ratio.
Potential loss is $ 500.00 which is half of $ 1,000.00 . There are
other more complex formulas, such as comparing it to risk free
investments such as Treasuries, & also comparing it to its own bond
yield (vs) stocks earning yield. There are various approaches to
investment management. I will have more on this later in a follow up
Article: Engineered Portfolio Construction . Link
http://www.groups.yahoo.com/group/AAQuants/join Please Forward this
link to a friend. ~ Bill ~
---------------------------------
Do you Yahoo!?
Check out the new Yahoo! Front Page. www.yahoo.com/a
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