If you are a day trader, you know how crucial it is to retain your invested capital and not lose it.
Every trader enters the stock market only to make profits. But, in their desperate attempts to get rich, they often make mistakes, which result in the loss of capital. To recover the lost money, they make hurried decisions, resulting in even more losses.
If you have been looking for the best ways to stay consistently profitable, this blog is for you.
Most legendary traders agree that the market rewards the patient. And a day trader who has entered the market for making big profits understands how important it is to preserve their capital while placing bets on a stock’s momentum.
Why Do Day Traders Fail?
Day trading is regarded as the best way to make money in the stock market. However, you would still hear more failure stories than success stories.
So, why does this happen?
As a day trader, you have to keep track of too many things in too little time.
First, you have to understand and evaluate chart patterns carefully. A stock can give you entirely different signals on monthly, weekly, daily, and hourly charts. Only by understanding how support and resistance levels work on each can you identify a pattern.
Second, you have to keep in mind the various rules, like wash sales, to carry out your trades efficiently.
Third, you have to understand the risk-reward ratio, which plays a decisive role in preserving your capital, locking profits, and minimizing the losses.
What Is Risk-Reward Ratio?
A stock moves in two directions – up or down.
When you put money in a stock, you expect its price to go up or go down. When you buy, you are going long. Similarly, when you sell without owning the stock, you are going short.
Irrespective of whether you are going long or short, there is always the possibility of stock going in the opposite direction. The risk-reward ratio helps you determine the risk you can take compared to the profit you can make.
Generally, the risk-reward ratio depends on your experience level.
Most novice day traders keep 1:2 as the risk-reward ratio. The 1:2 ratio means that you are ready to lose half the amount you are willing to earn. Hence, if you are buying a stock whose current market price is $50, and if your profit target is $10, the stop loss would be $5.
As you gain experience, you may gradually keep on increasing the ratio.
Why Is Understanding Risk-Reward Important?
The Risk-Reward Ratio Improves The Win Rate
As a day trader, you have to accept that losses are as much a reality as profits. It is ultimately the win rate, or win-loss ratio, which matters. When you have a higher win-loss ratio, calculating the risk-reward becomes easier.
The win rate is the rate at which you make profits.
Let us assume you take ten trades every day, and you win seven and lose three – this means a win rate of 70%. Typically, the win rate is calculated on a monthly basis.
The formula of calculating the win-loss ratio is simple – calculate your total wins and losses, and divide the wins by the losses.
Generally, a win-loss ratio of 1.5 and above is considered as a high win-loss ratio. It is advisable to test your strategy on paper before putting in real money.
When you have a fair idea about your win rate, you can better calculate the risk-reward ratio. With a higher win rate, you can keep a higher risk-reward ratio. However, if your win rate is below 1.5, you have to keep a lower risk-reward ratio.
Simply put, if you make profits 70% of the time, your reward should be enough to take care of 30% of your losses. Hence, having proper knowledge about your win rate can help you to determine the profit factor.
Risk Reward Ratio Helps You In Avoiding Mistakes
Quite often, you would find novice traders making the cardinal sin of keeping unrealistic profit targets and ignorable stop losses.
For example, you would often find novice traders keeping a profit target of $10 and a stop loss of $2. While this approach certainly increases the reward to risk, it plays truant with the win rate. In this case, the probability of the stop loss getting hit is more than the chances of the target getting hit.
Having a realistically calculated risk-reward ratio helps you understand how much profit can help you achieve the goals you have set for yourself.
In trading, the strategy is everything. Without a robust and time-tested strategy, you can never expect to be consistently profitable.
If your strategy gives you a win rate of 70%, you can keep your risk-reward ratio at 1:5 and above. If, however, your strategy fails more than it works, it is better to have a more humble risk to reward ratio.
Risk Reward Ratio Helps You In Choosing The Right Stock
If you have the proper knowledge, you can expand the list of instruments and the sectors you trade.
Stock price movements depend on multiple factors like liquidity, economic and political news, flash news, events, fundamentals, and technicals. Imagine you choose to trade in a sector that has been in focus for government policies. The chances of getting a better reward are higher in such sectors.
On the contrary, if you select a sector that has been a victim of bad events, the risk will be substantially higher than the reward.
Hence, the risk-reward ratio is not static; it is dynamic. You must keep your eyes and ears open to analyze the trend and calculate your risk-reward accordingly.
How To Calculate The Risk-Reward Ratio?
Calculating the risk-reward ratio is not as difficult as it may seem at first.
To calculate the risk-reward ratio, you must have three things ready – the entry price, the take-profit price, and the stop-loss price. The formula for calculating the risk-reward ratio is RRR = (Take-profit price – Entry price) divided by (Entry price – Stop loss).
Let us understand this with an example.
Assuming the stock price at US$100, the take-profit price at $120, and the stop-loss price at $90, the RRR would be the following –
RRR = (120-100)/(100-90)
RRR = 2:1
Hence, for every $2 your earn, you can risk losing $1.
Day trading is no more what it was a decade ago. Now, most big traders use Algorithmic trading, or Algo trading, to get an edge over the retail traders. With an Algo trading set-up, keeping your risk-reward ratio is as easy as keeping the win rate higher, resulting in consistent profits.