One of the most deceiving statements in trading is "You need to risk more to make more" or "Risk a lot to make a lot." That's simply not the case. On the contrary, traders should seek to risk less on each trade in order to make higher returns. Here's how to do it and why.
- Risking small amounts on each trade, such as 1% of the account balance, is more likely to produce big returns over the long run than risking 20% of the account.
- Once you decide how much you can risk, you need to determine your entry point, stop-loss, and profit target.
- Ideally, take trades where the risk/reward is less than 0.5, but the smaller the ratio gets, make sure the profit target is still likely to be reached.
- Think small: Cap your account risk and trade risk, and then set reasonable targets that are likely to be reached.
Keeping Trading Risk Small
When it comes to trading risk, most people have it all wrong. Risking small amounts on each trade, such as 1% of the account balance, is more likely to produce big returns over the long run than risking 20% of the account.
The reason is that no matter how good a trader gets, losing trades happen, sometimes several in a row. The more risk on each trade, the higher your "risk of ruin," which is the possibility that you could lose everything.
By risking 1% of your account balance per trade, your risk of ruin is very low.
How you use the 1% is key, though. If you have a $10,000 account, risking 1% doesn't mean you buy $100 worth of stock (or other assets) and let it ride. Instead, you take the 1% and combine it with a stop-loss and profit target to maximize the efficiency of your deployed capital.
Risk/Reward Ratios and Win Rate
You know how much of your account you can risk, but now you need to determine how that capital will be used. To do that, you need to determine your entry point, stop-loss and profit target. For example, stock ZXYZ is trading at $17.15. You want to short sell it at $17.11, and you have a $10,000 account. By risking 1% of your account, you can afford to lose $100. From looking at the stock chart, you decide to place a stop-loss at $17.22 for your day trade. You are only risking $0.11 per share, but you are allowed to risk $100, so divide $100 by the risk per share ($0.11), and you get 909. That's how many shares you can short sell (position size). Round it down to 900.
Also from looking at the price chart, you determine that $16.70 is a good profit target. Based on your entry point, that gives you a potential $0.41 profit. The risk/reward ratio is $0.11 divided by $0.41, for 0.27. Your risk is only about 1/4 of your potential profit. By capping both the risk to your account, and the risk on your trade with a stop-loss, you're not likely to lose more than 1% (slippage could increase the loss slightly), but if you win your trade, you will make close to 4% profit on your account balance (because you risked 1%, and your potential profit is close to four times your risk).
Four percent on account equity is a big gain for one trade. A few winning trades result in a gain that most investors realize over the course of a year, yet our risk is still very low and calculated.
The risk of ruin is near zero, and yet we can make huge gains by keeping risk small.
The risk/reward isn't the only factor we need to consider, though. A great risk/reward ratio is useless if the profit target has almost no chance of being hit. This is where most traders go wrong. They learn about risk/reward ratios and think a 0.1 ratio is better than a 0.5 or 0.75 ratio. That's not necessarily true. You need to set the stop-loss and target for each trade based on what is reasonable (recent price action), not what you want to happen.
Ideally, take trades where the risk/reward is less than 0.5, but the smaller the ratio gets, make sure the profit target is still likely to be reached. An outlandish profit target that is never reached is useless and just means you are stopped out (i.e., lose) on your trades more often.
Practicing your strategies in a demo account for several months will give you a good idea what sort of win-rate (probability of a successful trade) and risk/reward ratios work well for what you are trading.
Trading Small Produces Big Returns
By risking a small amount of your account on each trade, you greatly reduce your risk of ruin and could have bigger returns than those who are swinging for the fences with big-risk trades. A trade with a favorable risk/reward ratio means you can risk 1% of your account but make up to 4% or more on a trade in a matter of minutes. Even if you only win 50% of your trades, the resulting daily gains can be large. Doing it day after day—keeping risk small and calculated—can result in a large compounded yearly return.
Think small: cap your account risk and trade risk, and then set reasonable targets that are likely to be reached. That's how you make big returns while only risking a small amount.