Risk, Profits, Key Levels – Your Magic Formula

Every strategy should give you an exact place to exit. And this means accepting the fact that the stop placement for a loss is going to be as important as the profit target. You should always have a specific plan in mind with EVERY trade. If you do not know where you are heading with a trade, what the desired outcome is (and we mean not winning – but a precise objective) then you are going to make bad decisions as that trade develops.

This means coming up with rules for every occasion. This is a challenge at least initially when crafting a system since you want to get to the point that if you had to, you could program at least 90% of the system into a computer. Some of the best strategies still require some “art” and “experience” and that’s perfectly fine. The mark of a great strategy does not mean it has to be fully programmable. But you should be able to program 80% or 90% of the rules. The other part, the subjectivity, that is made up of the art and experience you can use to influence the final decision.

What we find though is that most traders enter trades without knowing where they are heading and they end up making all kinds of bad judgment calls. The trade goes against you, as most trades tend to at some point, and you panic out. The trade goes a little bit in your favor, you panic and take the profits, missing out on the next minute or day where it spikes up your way. Or, it starts going way against you but you become paralyzed with fear and do not exit, you might even buy more on the decline.

Not having a plan is a formula for total failure. You may as well mail in your account directly to the broker’s bank account because it won’t be long for that account to be wiped out and you cannot blame your system, your signals, your indicators or anything else if you do not have a plan to follow.

And realize that even the most experienced traders fall victim to this as well. I would love to tell you that I have never overrode my plan, jumped out of a trade too soon because I thought I knew better than the markets and strategy only to leave a lot of dough on the table, but it is a reality that every trader continues to work through.

What I can assure you though is if you do not have a specific plan heading in your trades, your results are all but assured and they will not be favorable.

What to Risk?

There is no single formula that will work in all cases, for all markets. When building our targets and risks we also do not get hung up on making sure the target is 2x, or 3x or 1.5x as large as the initial risk. Sure, this is always nice when you can trade a strategy where the targets are larger than risk. But this doesn’t mean much if the win/loss ratio isn’t where it needs to be, or if you end up risking too little, constantly getting whipsawed out of trades just trying to keep your ratios up on your target to risk.

You need to make sure you realize that it matters what the ratio is, but as important is the win/loss ratio – the bottom line of what you’ll get out of a trade. Think of it this way. If you had a strategy that won 90% of the time, would you trade it? You would unless you found out that it does that by taking very small profits and when it loses, the risk is so large it can wipe out every win. That same 90% win/loss ratio could be great though if the risk was larger than the target, but in a manageable amount – maybe your risk $1.50 for every $1.00 profit. At first that doesn’t look compelling, but with that type of win/loss it would make for an amazing outcome.

What’s important here is to not get hung up on any one variable. We have frequently talked to traders who have become convinced that unless a strategy wins xx% of the time, or it has a 2:1 target to risk ratio, that it is not going to succeed, yet the same thing they are attempting to achieve that meets their criteria could easily end up being a dog of a strategy because they have neglected the other variables.

Here is an example of a Forex trade. We like to start by looking at our strategy’s entry point and then subtracting it from our stop area. Frequently, the safest stop areas are below the last major swing low (when going long) or swing high (when going short) – you come up with a value and then that becomes your risk. Try to use that as your profit targets when testing a system. This is a perfect place to start. It is basically 1:1 and you’ll find that many strategies that have accurate and successful entries will do a near perfect job many times of satisfying that projection in a percentage that is acceptable (of course above 50% and we like to see that occur 65% of the time to call it a definite success.)

In this example the difference from entry to swing low is 34 pips. The target is there for 34 pips above the entry – and more interesting is that the exact swing high was the calculated target. Of course it is not always going to be perfect but it is fascinating how often it will be quite close. If you find after some testing over 10, 20, 30 trades that you are frequently just missing target, or the market is going way beyond your target the majority of the times, then you just adjust your ratio and go for the risk times whatever you need to pick up that 65%+ win ratio. As long as you stay close to 1:1 or better you’re going to be “golden.”

Here’s another example of a stock, on a daily chart. Assuming your entry rules had you short at the opening of the bar you see below (49.71) you have a projection of 6.54 between the entry and the swing high. This then gives you a basis for both a stop, and your projected target, which is reached in this example. Of course, you need the rules that get you in at successful entry points but building the targets/stops from basic understanding of swing highs and swing lows (no matter the timeframe whether intraday or multi day or weeks) and projecting from there is the basis for this exact plan you will need.

You also need to have rules that tell you what to do when you get close to target which we cover in another article in detail.