From the March 01, 2011 issue of Futures Magazine • Subscribe!

The trader's equation: Should I take this trade?

When you consider a trade, you ask yourself: "Will I make money on this trade?" The decision is based on an assessment of the mathematics of the setup. Although the trader’s equation may not come to mind explicity, it is always the basis for the decision. You will take the trade if you believe the chance of success times the reward is significantly greater than the chance of failure times the risk.

There are three variables in the trader’s equation, and we can control two of them and estimate the third. The risk is based on the protective stop. If the stop is two points from entry, then the risk is two points. The reward is based on the profit-taking limit order. If the target is two points from the entry, then the reward is two points.

Most traders should not take trades when the reward is less than the risk because an unrealistically high winning percentage is necessary to be profitable over time. For example, if a trader risks three points to make a one-point scalp, he has to win about 80% of his trades just to break even (and the goal should never be to just break even). To make a living trading this risk/reward profile, the trader would have to win about 90% of the time. And this level of performance would have to be maintained month after month, year after year. If this trader took 10 trades using a one-point profit target and a three-point stop and won on seven and lost on three, he would make a total of seven points and lose a total of nine. Even though he won on 70% of his trades, he still would have a net loss of two points.

You also have to allow for commissions, slippage and the occasional mistake.

The third variable

As a general rule, do not take a trade unless the reward is at least as great as the risk. As such, the trading decision always should begin with an assessment of risk. Risk is defined by the distance of the stop. If two points are risked in the E-mini on the five-minute chart, the trade only should be taken if two points of reward reasonably can be achieved. Risking two points to make two points needs, realistically, a 60% winning percentage to provide profits over and above commissions, slippage and mistakes.

Is that realistic? If the trader carefully picks setups, it can be. Alternatively, if only the best two or three trades a day are taken with a four-point profit target and a two-point stop, a 40% success rate may be viable.

For example, if four points each were made on four trades and two points were lost on the other six, 16 points would have been gained and 12 would have been lost, for a net of 4 points or 0.4 points per trade. After commissions, this is about $20 per trade per contract in the E-mini. A 60% win rate would increase profit per trade to 1.6 points, or $70 per trade after commissions. At two trades a day, 10 contracts at a time, this is $1,400 a day and more than $250,000 per year. Bottom line: If reward is at least as large as risk and if the win percentage is more than 50%, a trader is in a position to make money.

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