Risk:reward is the most important aspect of contrarian trading and investing. This is what risk:reward means:
If you go long when the market is falling or you go short when the market is rising, do you have a margin of safety on your side? If you WAIT long enough, will your loss turn into a profit?
Here’s an example. Let’s assume the market is making a correction and you know that this is still a bull market. The market falls 10%.
After falling 10%, you know that the market may or may not fall another 5%. Maybe the bottom is already in, or maybe the market still has some room left to fall. In this case, your “risk” is 5%. But what about your “reward”?
The “reward” is the minimum upside potential for your trade. I.e. “after the market bottoms, how much can it go up”?
In our example case, the minimum reward is 10% because the market has to make a new all time high (it’s a bull market). Ideally, a trade’s potential risk is less than half that of the potential reward.
When you asking yourself “is risk:reward on my side”, you’re essentially asking
In the worst case scenario, if the trade continues to go against me, will the market at least bounce back to my breakeven price and let me get out of the position without a loss?
When to use the concept of risk:reward
Risk:Reward is used when deciding to open a position and deciding to close a position.
There is no certainty in the markets. A reader once asked me “Once the stock market’s small correction starts, how would you decide when to get back into the market (the bottom)?”
The answer is simple: just get in when the S&P falls 6%. Yes, the “small correction” might extend to 7%, 8%, 9%, 10% etc. But risk:reward is on your side! Maybe the market will bottom at 6%. If you don’t buy at 6% and the market takes off, you will miss out on a big chunk of the next rally! The risk is limited: the market will at most fall a few more percent. The reward is MASSIVE. The S&P can rally 30%, 40%, or 50% before making the next “small correction”!
So ask yourself this question
Are you more afraid of missing out on the trade or being wrong?
Likewise, use the concept of risk:reward when deciding to take profits. Yes, the market’s current trend might continue a little longer and your profits might become even bigger. But if the odds of the market going against you soon are high, then the risk is too high to justify such a potential reward. Don’t be greedy. Take your profits when the risks are high. My favorite line from Reminisces of a Stock Operator is “the final 1/8th is the most expensive 1/8th”.
Risk:reward DOES NOT apply if you’re holding ETFs that face erosion
The key to risk:reward is that you have to be able to hold your position until you are right (i.e. profitable). This is a problem for some leveraged ETFs that erode like crazy. Here’s an example with VXX.
VXX is VIX’s ETF. If you just went long VIX at $10, that’s a guaranteed winning trade. You might have to wait for a few months, but VIX will eventually spike above $10 and you will earn a profit.
However, you can’t trade VIX outright. If you buy VXX, you might have risk:reward on your side, but you can’t hold until you’re right. VXX erodes like crazy. So if VIX is still at $10 a few months latter, the value of VXX might be cut by 25%!
Here’s an example with VIX being essentially flat.
Here’s VXX. Notice its erosion.
You can hold VIX until you’re right (risk:reward). But you can’t hold VXX until you’re right because its erosion will kill you.