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Explaining stock trading: 2 simple ratios that show whether you lose or make money

Thursday, 7 August 2014 - 1:30pm IST | Place: Mumbai
  • RNA Research & Archives

The Entry Hurdle into the business of Stock Trading/Investing is the least. You can open a DEMAT account in a couple of days and you are all set to make a quick buck.  Short term trading gains surely gives you a sense of instant gratification and a feeling that you can make money really fast.  But key to lasting longer in this game is discipline and Risk Management.

There are 2 simple ratios which decide whether you make or lose money in Stock Markets:

Success Ratio  - Which defines how many times you go right

Risk Reward Ratio – Which defines how much you gain when you go right and how much you lose when you go wrong.

Poor traders usually assign great importance to the first ratio and try and find a study which gives them maximum success ratio but neglecting the Risk-Reward equation. Imagine you make 100 trades and decided that you will book profits if you make Rs 200 and exit in loss if you are losing Rs 100. This is a scenario of Risk Reward ratio of 1:2.  If you are an expert and achieve a success ratio of say 70% it will mean, 70 times you made Rs 200 which is Rs 14000 and 30 times you will lose Rs 100 which is Rs 3000. So your net profits will be Rs 11000. Suppose someone has a success probability similar to a toss of a coin, then out of 100 trades in 50 he gains Rs 200 making Rs 10000 and in 50 trades he loses Rs 100 losing Rs 5000, still making a net profit of Rs 5000.

The key in the above example is that even being right just half of the times someone can be net-net making some money.  The crucial part in the above example is the risk reward set up. It is ensuring one is losing only half of what he would gain if he goes right. In this scenario at a success ratio of only 33.33%, you will still break-even. Only below 33.33% success ratio you would start losing money.

In real life, most losing traders are doing the opposite. They would book profits at say Rs 100 when they are in a profitable position in the fear of losing the profits and end up losing 200 INR in the loss making trade waiting long enough in the hope that the loss would have turned into profit.  In such a case even if you achieve a success ratio of 66.66% you will still just break-even.

Most Mechanical trend following systems have success ratio below 50%, but they make sure that the loss making trades make smaller losses which will get compensated in the big winning trades.

‘Emotions’ plays a key role in such scenarios because as humans we always want to win and cannot accept the fact that we are wrong.  Traders take loss making trades very personally and attach to themselves and doubt their trading abilities and methodologies. Traders should accept that we are dealing with Forecasting the future which is only a Probability and there will be trades which will go wrong.

There is no methodology which will give you a 100% hit ratio.  Key to survival is Risk Management and a methodology with Risk Reward in your favor. Traders FEAR that profits will vanish and cut a profitable trade fast. They will hold on to loss making trades in a HOPE that the loss making trade will come back to profits.

For being a successful trader you just have to reverse these two Emotions. FEAR that a loss making position can get into an even bigger loss and cut it as early as possible and HOPE that the profitable position will get into an even bigger profit and hold on to it.

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