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Monday, November 12, 2007

Money Management: Reward Analysis

You might notice that I am reposting my money management thread from my forums. I understand that those of you who have read this before might have already read this, but the topic is just that important, that I want to go over it again; in this venue (the blog). It's that vital. And it helps other folks out who have not read the forum before.

Now, what of that 'dark side' that I mentioned when it comes to risk analysis? At times, ones will become so concerned with risk control, that they give no thought to the reward. For example, what if a trader was so concerned with limiting risk, that they engaged in buying cheap, severely out of the money options? Is their risk limited? Yes. Let's say that Sugar is trading at $10.00 and we expect it to fall to at least $9.25. Instead of buying a $9.50 put option, what if they were to reason "Well, I can buy a 750 put option, for only $11.00. That way, my risk is limited to $11.00."

The question becomes, how reasonable is this? Will the market move close enough to 7.50 for that option to become worth anything? Honestly? So did the trader limit their risk? Yes. But they didn't sufficiently consider their reward, or analyze for a reasonable reward, for that limited risk. All they end up doing is throwing away money on cheap options, and nickle and diming themselves to death.

Every human on the planet engages in reward analysis. Open-mouthed Sound familiar? Well, it's true. We talked about Chrysler offering Joe a job. There were risks, ah, but what about the reward? The money in the form of a salary and benefits that Chrysler is offering Joe is very nice. So, what does Joe do?

He balances the risks against the reward.

That is key. That is fundamental to good trading. This is something that 99% of small speculators never consider. They never look at a trade, and look at the balance between the risk, and the reward. Which is ironic. Because any good businessman balances those two factors.

You must plan out what a reasonable reward would be. A good rule of thumb, is that any reward should at the very least be twice as much as your risk. Why in the world would you become involved in any business where the risk was greater than the reward? You'd be setting yourself up for failure.

I can't tell you how many traders I've seen consistently risk $3000.00, seeking a $500.00 reward. Mathematically, they are bound to fail. It's a certainty, and is so obvious, it needs very little explanation although mathematically it has been proven again and again, such as in this linked example.

What a trader needs to do, is consider what is termed the risk / reward ratio. 1 risk, to how much of a reward? The ratio should be at least 1:2, and preferably, rest around 1:4.

Now there I do provide caution here. You must plan out a reasonable reward. This means that there should be market conditions, tools, and indicators that provide and seem to signify that the market can reasonably reach your goal. In the above example, we would like Sugar to go to $3.00. However, historic volatility in that market demonstrates that this is not a reasonable conclusion.

So plan out something, that given historic volatility, the market can reasonably reach that will give you a reward 4 times greater, than your total risk.

So what do we have to date? A few rules.

1) Limit your risk. Determine ways to limit your risk. Do not risk more than 3% of your account on any one trade. We'll talk more about how that number can be adjusted later, but for now? That's your baseline. Risk 3% of your total capital on one trade. This leaves you alive to trade another day, in case something horrible happens on your one trade.

2) Also, plan out a reasonable reward given historical volatility that is at least twice as much as what you are risking. Preferably four times.

We will continue with another aspect that needs desperate attention by most traders, and something that relates to our reward. Proper trade management. Because there is another caution. There is nothing saying that the market will make your reward goal. So what are you to do? We'll talk about that in the next blog . . .

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