We added a simple but very important feature to the Stockscores charts this past week. In the charting tab you can control the settings of the Stockscores charts and you will now find the ability to draw reward for risk lines on the chart.
This is a simple tool but it is based on one of my core philosophies about the market. While most investors are focused on buying or shorting the right stock, what everyone should focus on is risk management. Understanding the relationship between reward and risk is essential to being successful in the market, whether you are a short term trader or a long term manager of a retirement portfolio.
When most people judge a stock trade, they do so by looking at how much money they made. A trade that makes $2000 is better than a trade that made $200.
What would you say if we expanded our judgment of these trades to include some reference to the risk taken? If you risked $5000 to make $2000, is that a good trade? What if you risked $100 to make $200?
With this in mind, the second trade now looks like the better one. You may be wondering, however, how we measure the risk of the trade.
Risk is not about how much of the stock you buy. You can buy $100,000 of a stock and only have $1000 of risk. Risk is controlled by limiting the downside with a predetermined stop loss point. If you buy a stock at $10 with a stop loss at $9, you are risking $1 a share. If you buy 1000 shares, your risk is $1000.
This assumes that you have the discipline to hit the sell button if the stock falls to $9 and that it does not gap down through your stop loss price to give you a bigger loss. As long as we keep our discussion simple, this is a good definition of risk.
Reward is the difference between your exit price and your entry price. Sell this stock at $13 and you have made $3 of reward for $1 of risk giving you a reward for risk of 3. Essentially, this means that this winner pays for 3 losers.
You might be thinking about this concept with the idea that using a tighter stop loss point can really improve the reward for risk metric. If so, you are right, a stop at $9.50 rather than $9 now gives $0.50 a share of risk and $3 of reward for a reward for risk ratio of 6. By tightening the stop you have doubled your reward for risk.
Of course there is cost to using a tighter stop. As you narrow the difference between your entry price and your stop loss point you also lower your chance for success. The trick is to find the best point for that stop where you can maximize your reward for risk without sacrificing your probability of making a profit.
To help you with understanding reward for risk, we have added a tool to visualize it on the Stockscores charts. If you go to Stockscores and call up any chart, you will see a Charting tab either beside the small format charts or below the large format. At the bottom of the Charting tab are places where you enter the Entry and Stop Loss price. Then click on Create Chart and you will see those lines drawn on the chart, showing the reward for risk multiples. I use these lines to measure my success on trades but also to help me pick exit points. That method is something I teach in my trading courses.
The most important takeaway from this new tool is the importance of planning your losses. You should always pick a stop loss point and stick to it to limit downside when you make a failed trade. Holding on to losing trades is the greatest failing of investors.
Stop your losses when you are wrong and let your profits when you are right. Hopefully this new tool will help to emphasize the importance of this simple but often overlooked concept.
The markets made some positive steps toward an end of the weak and uncertain markets that we have endured for the past few months this week. Performance on Thursday and Friday were a good show of optimism in to next week. I am cautiously optimistic that we are in the early stages of a summer rally that can hopefully get started once the psychological overhang of the Greek election has passed Monday.
Trading on Monday will be critical to determining whether the buyers can take back control of these markets. Investors were speculating this week that they would but I think owning a lot of stocks in to Monday was too risky for most.
If the market is able to remain stable, I think we can start to accumulate stocks again after being mostly in cash for some time. Here are a few stocks that made decent showings on Friday and have some potential.
Long a dog among the Canadian large cap companies, T.ECA is starting to turn around. The stock has a lot of work to do still and I consider a trade on this stock having about a 50/50 chance of working. However, if it works the upside is far greater than the downside, making it a stock worth considering. Has a nearly 4% yield. Support at $20.50.
PVA is another Energy stock, a sector that was a leader on Friday. This stock has a similar chart to T.ECA and I would not take a trade on both as they will be highly correlated to one another. An inspection of the chart shows that this stock has had a sub 60 Sentiment Stockscore for many months but has moved up and through that important threshold in the last couple of weeks. Today, the stock broke out through resistance with abnormal volume, a positive sign that it wants to go higher. Yield just above 4%. Support at $5.50.
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This is not an investment advisory, and should not be used to make investment decisions. Information in Stockscores Perspectives is often opinionated and should be considered for information purposes only. No stock exchange anywhere has approved or disapproved of the information contained herein. There is no express or implied solicitation to buy or sell securities. The writers and editors of Perspectives may have positions in the stocks discussed above and may trade in the stocks mentioned. Don't consider buying or selling any stock without conducting your own due diligence.