Understanding Risk, Reward and Probabilities in Trading

When individuals set out to initiate their trading endeavor they have three aspects of trading they have to hone-in on. The first is risk, which is the easiest to figure out. Most new traders quickly grasp this concept.

 

How to Calculate Risk on a Trade

Measuring the risk on a trade is simply a measure of the amount of money exposed between the entry and the stop loss. A simple example would be in a trade of WTI (West Texas Intermediate) Crude Oil for the March Expiration (CLH20).  In this particular contract, every one dollar move is worth $1000. This value is derived by the fact that every contract in CL controls 1000 barrels of West Texas Intermediate Crude Oil. The smallest incremental price move (called a tick) is .01, thus there are 100 ticks in a point. Since there 100 ticks in a point ($1000/100) every tick has a value of $10.  If a trader buys 1 contract of  CLH20 at a price of 52.30, with a stop market order of 52.10 her risk would 20 ticks (20 x $10 ) would equal $200 of risk per contract.

 

How to Calculate Reward on a Trade

The next facet of trading is the reward. Since trading is about risking money, the reward should compensate a trader at a favorable ratio, at least three times the risk. In this oil trade example, the market should allow for at least a $600 profit potential.  This can be projected by understanding where price is likely to turn against the trade after it starts to move in a favorable direction.  In the long oil trade example, a trader must objectively find where the sellers are found on a price chart to know where price might turn against the long trade. This would look like a fresh quality supply zone opposite the buy zone from which the buy was executed.

In the two charts below, we see a recent setup in CLH20 the fit these two parameters.

In this first chart we see a quality demand zone that would likely produce a turn in price because price hadn’t returned to the price level after producing a strong rally.

In the second chart below, we see that there is a gap in price which insinuates that there are plenty of sellers at that level, as the sell orders were so overwhelming that the price gapped lower.  This is where a trader can objectively seek to take profits. In fact, a better chance of hitting the target would be to place the target 20% before the selling zone.

We can see the outcome in the chart below as price rallied into the supply zone and immediately turned lower. If the trader had not looked at this information objectively, she may have let her emotions take hold and may have not taken her profits.

 

Probabilities

Probabilities are, in my experience, the most challenging aspect for traders to quantify. One way to think about probability is to look at it as the location where the odds would favor buying, or selling.

In the oil example, buying was a more favorable opportunity as the price of oil had fallen more than $12 and was approaching a longer term area where buyers had stepped in and purchased lots of contracts in the past year. This, coupled with the fact that Oil had been in a well-defined range and had fallen from the top extremity to the lower boundary of the range, made this a higher probability setup. This is seen in the chart below.

In conclusion, in order for a trader to experience consistent results, the first step is to formulate a process that can clearly assess risk, reward and probability. Those that fall short of doing that are not likely to see favorable results.

Until next time, I hope every has a great week.