Risk, Profits, Key LevelsYour Magic Formula

By: Mark Soberman
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.

Investment
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