Stocks can go up, down, and up and down. At any given moment, the price can rise or fall for a host of factors. A financial whale could be making a large purchase that could cause a temporary spike in the price, or a large corporate insider could unload some shares to fund a new boat, causing a temporary decline in the price. The point is, at any given time, the price movement is totally random. The shorter the timeframe, the more random the price moves will likely be. So, with such random results, how can we reasonably expect to make money over time in the stock market? Wouldn't our results also be random? Under normal circumstances, the answer would be yes, but with a couple of key preconditions, we can weed out the setups that don't offer something substantial enough to offset their random result.
Even if we zoom out to a daily chart, the normal volatility that a stock or index experiences on a day-to-day basis appear to be totally random. So much so, that we've come to expect a trade result to only have roughly a 50% chance of success. See the problem? With a 50% probability of profit, we can't really expect to make money over time. Half would end up as winners, half losers, and the house would slowly bleed us of our capital with commissions and fees.
But, traders have an edge. We don't HAVE to play until everything is lined up just right. If we can only expect half of our trades to be winners over time, then we better make sure that the winners are bigger than the losers. In other words, if the setup doesn't offer us a lot more reward for being right than it costs us if we are wrong, we pass on the trade.
To see how this works, let's assume a game of coin toss. For every head, you get a dollar and for every tail, I get one. If it cost each of us a penny in fees to play, it would only be a matter of time before we both run out of money. But, if we change the scheme so that you win $2 for every tail, and only lose $1 for every time the coin comes up heads, the entire dynamic has changed. The probability of profit (PoP) remains exactly the same at 50%, but the reward is now double the risk, making it a very favorable trade setup.
Let's look at a few charts to see how the reward-to-risk (R:R) profile can change depending on when you purchase the stock. First, let's look at a stock with roughly an equal reward-to-risk ratio. This would be similar to the coin toss game where the odds of success are 50%, and the reward is equal to the risk.
In the chart of TTWO above, we can see where former resistance and support might lie. At least, we know that in the past, the sellers emerged near the top of the channel, and buyers managed to stop the decline at the bottom of the channel. We can't possibly know for certain if the buyers and sellers will emerge again at the same price, but without any insight into what the future will bring, we are forced to use prior "pressure" points on a chart where the price reversed.
At a glance, we can see that the green, which represents potential profit, is roughly the same as the red, which shows what you have to lose if the price falls back to support. With the reward being very similar in size to the risk, we would pass on this trade. Note, using moving averages or other indicators not currently shown on the chart may change the dynamic and make this a good trade, but for the purpose of this illustration, we are using the support and resistance levels that we highlighted.
Now let's look at another channel trade, but one that has a different risk profile.
With INTC, we apply the same 50% probability of profit. We think the chances of it continuing lower are roughly equal to the chance that it will bounce and close the gap. If either outcome is equally likely, then we have to get lucky in order to expect to gain wealth over time. But this time, we earn roughly $4 for being right, and we only lose $1 if we are wrong. With an R:R of 4:1, we can be right less than half of the time and still make money over the long run.
Now let's take a look at a setup that is near the top of its channel to see if it would make sense to buy at its current price.
In this example, the price is very close to the top of its recent channel. Now, it very well could continue higher here, but the last time it rose this high, the bears wrested control and drove the price lower, so we are going to assume the possibility that they could do so again. If we apply a 50% probability that it will continue to its upward resistance and a 50% probability that will instead fall back to the bottom of its channel, the trade would make no sense to make because we stand to lose much more if we are wrong than we would gain if we are right. Trades like this will all but guarantee a slow decline in wealth. Note, this could become a great trade if it does manage to break above resistance, but as illustrated, the reward is minuscule relative to the risk.
These examples are just examples. Different traders might choose different points on the chart that they use as potential support or resistance. Our preference is to use prior lows or highs, or major moving averages. Both stand a good chance of influencing the price behavior, so we take them into consideration when attempting to guess a specific outcome. A stock with a poor reward-to-risk ratio might do fantastic and a stock with an extremely asymmetrical reward compared to the risk might do terribly. The difference with watching your risk profile and only attempting trades that are heavily skewed away from risk and towards reward, is that you are compensated handsomely for being right, and your account will only receive a minor ding if you are wrong.
For some traders, the missing link to success is that they don't focus on trades with asymmetrical rewards. Start focusing on trades that favor reward, and watch your portfolio results be the better for it.