Risk Reward Rebooted

Risk comes from not knowing what you’re doing – Warren Buffett

Recently Sam & I have received various questions on the nature of trade management decisions in conjunction with the concept of risk & reward profiles. Admittedly, trade management is possibly the most difficult part of any trading strategy so today let’s explore this topic a little more.

However keep in mind one thing: like with everything in trading, there isn’t an absolute right or wrong way to confront the issue of trade management. As we’ve stated in a previous article, trade management can only be evaluated correctly if it is connected to the objectives for the trade. It’s a question of mantaining a logical progression in the decision-making process.

In essence: the real risk comes from not understanding what you’re doing, whereas the real rewards come from having clear objectives and a clear decision-making process.

Time Exits

For larger market participants, time is a vital factor and timing based exit strategies are employed by some higher-end market participants. For example, FX Concepts (a massive FX hedge fund that relied mainly on various time cycles)  had dozens of execution traders working for them. These traders were executing the system’s signals,  and they were also paid a bonus if they could outperform the systems by using an alternative exit strategy. As a side note, some institutional clients that use our Active Trader Signals from Steve & Alan act in the same manner.

If the systems triggered an exit signal, the executing trader was allowed a window of a few hours to execute the trade. However, for FX Concepts, liquidity was an issue and their systems were designed to avoid trading during illiquid times (for example in the twilight zone between the New York close and the thin pre-Tokyo open).

Unfortunately, algorithmic market-making and trade execution has made liquidity much worse nowadays. Algos are responsible for 70% of the activity on the interbank platforms according to the last BIS report. This means that holding sizeable positions is potentially more dangerous nowadays (and is most likely a major factor in the recent happenings at Brevan Howard, Tudor Capital and Bridgewater).

So many of the large firms are actually less flexible than smaller participants (like retail traders and CTAs for example) as they need to time their exits around the major liquidity pockets of the day. This may also be one reason for the classic “New York Reversal” pattern: frequently a trade will progress well through London and then be halted during the initial hours of the New York session as a reversal pattern hits the market.

Bottom line: do not think, for one second, that fund managers or legendary traders have it all figured out. To a certain extent, they have “graduated” to more complex problems than retail traders have, due to their size. One market participant I spoke to said they have conducted “thousands of in-house permutations” and did not find any particular trade management solution that trumped the others.

Holistic Trade Management

Fortunately, smaller participants & retail traders share the same decision-making flexibility, which is a decisive advantage. As retail traders we do not have to wait for particular times to exit our trades. We can act based on our assessment of the situation, in conjunction with our objectives: a holistic way of managing our trades.

What this means is that:

  • the objectives for the trade should be established before entry
  • the objectives for the trade give a logical placement for the stop loss
  • the objectives for the trade dictate the potential reward
  • the market’s gyrations will dictate what happens once the trade is executed

Let’s discuss a recent signal trade: Long AudUsd.

Our Long AudUsd trade was entered at market (0.7686), with a stop loss at 0.7624 and a first target at 0.7715, a second target at 0.7743 and a final target at 0.7779.  Some considerations:

  • The way these targets are structured is that the initial target should be “easy” to hit intraday. The second target is effectively the “main” target for the day and the third target is for the runner.
  • The objective for the trade is intraday, so we are looking for a “quick push” in the right direction.
  • The initial risk is (0.7686-0.7624) = 62 pips
  • The targeted reward is (0.7715 + 0.7743 + 0.7779)/3 = 0.7745 or 59 pips from entry.

So our overall ex-ante targeted risk:reward is 0.95. Many traders would frown at this, because it’s not a “multiple-R” target. There’s a simple way to change the ratio: simply raise the stop! Perhaps to 0.7660? That way the ex-ante risk:reward ratio climbs to 2.26. While mathematically it can make sense, in practice it represents a trade-off which needs to be incorporated into the objectives & trade management details.

With closer stops, the risk of being stopped out and taking a full 1R loss increases substantially. For example, with a stop at 0.7660 AudUsd might have come back down to test the recent lows (hence stopping us out) only to move north again. Traders that set bold targets and either achieve them or take a full stop loss, are playing a number’s game that can work well in theory, but does not incorporate the “messy” nature of the markets. When the market starts moving towards your intended target, your risk is actually increasing because you have non-consolidated profits to lose, alongside your initial intended stop loss. What if the market forms a reversal pattern 10 pips away from your target? Do you close the trade? Do you scale out? Do you hold nonetheless? These eventualities need to be factored into the trade management plan.

What we do is judge the market’s performance at certain junctures during the day, given our short-term objectives. When the market rewards us with favourable movement, we will shift the risk:reward intra-trade by trailing the stop loss and thus limiting the tolerable adverse excursion. What was initially a sub-par risk:reward trade becomes acceptable. However, the market doesn’t always oblige and we are on the lookout for reversal signals. We will tendentially scratch trades that start to reverse, after having shown favourable excursion during the day.

The combination of accurate directional forecasting, initial wide stops, trailing stops and evaluation of market performance intratrade is the way we are currently operating the trade management side of our signals. This combination is directed at obtaining smaller, consistent returns over time. It’s but one example of how to manage trades in line with certain objectives.

The other consideration is that our trades are entered “at market” with no particular “trigger” formation. So for traders that have particular entry conditions, a different stop placement can be considered.  Another variable might be time availability: if you cannot monitor your trade frequently, your objetives will have to shift. You might not want to scale out of your positions.

There are endless permutations to be explored, and once again there isn’t a right or wrong approach. Keeping accurate trade statistics (using an independent service like Tradervue) will help you understand whether you’re on the right path or not. Just remember to record at least 30 trades using the exact same rules, before looking at the results and changing things.

Over to You

How do you confront the issue of risk vs reward, alongside your objectives? Is it in line with your objectives? Are you structuring proper objectives for your trades, and sticking to the plan? Come into the Trading Tribe and let us know: we’re here to help wherever possible.

About the Author

Justin Paolini is a Forex trader and member of the team at  www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.

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