MONEY MANAGEMENT

Risky Business

Risk/Reward In Trading

by Don Bright

Every investor and trader has been taught to be fearful of risk in the marketplace. That makes sense, right? You have to be cautious with your money, right? You have to limit losses, right? Well, maybe not.

As in most other things, risk in the marketplace comes with a counterpart: reward. These rewards can be financial, physical, mental, or even emotional. We all risk so many things every day, from the moment we get out of bed in the morning, head to work in traffic, engage our peers in conversation, and otherwise negotiate our way through day-to-day life. Even matters of the heart involve risk and reward; how many people are too afraid of rejection to pursue a satisfying relationship? For now, though, let's just take a look at risk and reward in the investment and trading world.

APPLYING STOP-LOSSES

So many of my learned peers support the theory of tight stop-loss methods when investing or trading. This seems to make perfect sense on the surface, but look a bit deeper. If you buy 100 shares of stock at $50, and hope to get an annual return on investment (ROI) of 12%, the stock would have to rise by $6 annually (assuming there were no dividends paid). To protect yourself from ruin, you can enter an initial stop-loss sell order to trigger at a predetermined price. How much should you limit your loss? How does this individual stock movement affect your overall portfolio?

Rather than go down the mundane road of percentage calculations based on overall bankroll (portfolio), standard deviation of historical volatility per stock/sector, and the whole number-crunching approach to what might happen if the stock were to move x percent over a t time frame, let's take a more universal and, yes, much simpler approach

....Continued in the October 2004 issue of Technical Analysis of STOCKS & COMMODITIES

Excerpted from an article originally published in the October 2004 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2004, Technical Analysis, Inc.


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