October 18th, 2013
by Gabe Velazquez, Online Trading Academy
A common perception among the general retail investing and trading public is that in order to garner large profits you must take on big risk. So where does this view come from? Who perpetuates it? And is it necessarily true?
Let’s tackle the first question: only high risk to get high reward. This view comes from the fact that most people perceive volatility and leverage as high risk. Therefore, if one engages in the markets during periods of high volatility using a leveraged product the odds are very low (high risk) but the profits can be huge, if things work out, is the common perception. In essence, the belief is that because most people are risk-averse they should settle for only mediocre returns as higher returns are only reserved for those willing to take on higher risks. We’ll address the validity of this belief shortly.
I’m sure most of you know that a belief system is not always created on the basis of factual information, but sometimes it’s the lack, or distortion of information that people believe. In other words, ignorance can also produce beliefs. In this case there are many folks that have a vested interest in telling you that low risk is commensurate with low returns. These are the same people that tell you that it’s impossible to time the markets so don’t even try. The lesson here is to be careful where you get your information and make sure you always do your homework.
As to whether there is any truth to the idea that there must be high risk in order to have high profit margins, long time readers of these articles know by now that it is indeed possible to take trades with very little risk when you can find the turning points. On one hand, it’s as simple as finding where the institutions have their unfilled orders. But on the other, implementation can be very challenging for some.
When we look at putting on a trade the three most critical components are, the stop, the entry, and the target. For the lowest risk entry we should always enter the market as close as possible to the point where we are going to be proven wrong. This would be where there are pockets of unfilled orders that originate a strong move. We refer to these as supply and demand levels. In the chart below we can see what the picture of a low risk entry may look like.
In it, we can see that the Russell 2000 E-mini on this day rallied off a congestion area (highlighted in yellow) and then pulled-back into that zone. The retracement into the zone presented a trader with a very low risk trading opportunity. The reason this was a low risk trade is because the entry was fairly close to the point where the level would be invalidated. Put another way, the point where we would be proven wrong. In addition, since there was no supply for a good distance also makes this a great risk versus reward. In this example, if you had traded one contact of the E-mini Russell 2000 the risk was approximately $100 for a profit of $830, and they told you had to have high risk. This can only be done by have a strong understanding of institutional supply and demand.
Speculating in the financial markets is about putting money at risk with the expectation that for that risk, we will be compensated. If that’s the case, doesn’t it make sense that we would only take trades that offer the lowest risk, highest probability (no guarantees), and highest profit potential? To do that however, we need a viable strategy, self-discipline, and constant reinforcement. Ask yourself if you have any of these when you trade, because if you don’t, you’re most likely taking high risk, low probability and small profit trades,and who wants to do that?
Until next time, I hope everyone has a great week.