Spread Risk in Risk Reward Ratio

Oct 5, 2007: 2:10 AM CST

Traders frequently discuss the “Risk to Reward” ratio when entering a trade, and often cite that it must be “Three parts reward to one part risk” or the trade will be deemed unacceptable from a risk standpoint.  But is this always the case?

It seems logical that the higher the reward/risk ratio, the better the trade, doesn’t it?  A trade with reward/risk ratio of 25 to 1 is far superior to one with a ratio of 3 to 1, isn’t it?  Who wouldn’t take the 25 to 1 trade?

Let’s look at it from the standpoint of normal volatility.

Just from a normal volatility standpoint (average daily price range movements, often designated by the Average True Range Indicator), the odds are far overwhelming that the market (price) will take out the one part risk before it grants you twenty-five parts rewards.

Stated differently, a stock is far more likely to move against you by one dollar than it is to move for you twenty-five dollars.

What might this do to an average trader’s overall picture?  A trader may have entered a “would-be” profitable trade, but he would never know because either the reward target was too large or the risk stop was too close.  Perhaps it is a combination of too distant target combined with too near stop.

Even reward/risk ratios of 5 to 1 can cause significant failures as a short-term trading strategy, because a stock – through normal volatility – is much more likely to move to take out the one part risk before granting the five part reward.

If the risk is $2 and target is $10, then normal volatility would state that the $2 stop would be taken out far before the complete $10 move has completed.

Sometimes, it is actually better to place the stop not just ‘beyond the noise,’ but far enough beyond the noise to be assured that any move that takes away your position was a valid one.

On the other hand, it may be more prudent to lower your profit targets to more reasonable levels, unless you deem yourself to be a position trader, in which case distant targets are acceptable.

But for most short-term traders, it would be better from a risk management and normal price volatility standpoint to set smaller targets and slightly wider than usual stops.

Of course, all this is predicated on the assumption that you have a trading system that grants you a greater than 50% win ratio.

When the odds of being correct are in your favor, it makes more sense to give yourself more room to be wrong (to avoid the “stop-gunning” or obvious pools of stops), and aim for a smaller profit target than to play for a large target and utilize extremely close stops.

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