According to Marketwatch, an analysis of trading-platform data shows that 80% of day traders are unprofitable over the course of a year.
So, what do the remaining 20% do different that makes them profitable?
The secret is that they understand THIS rule.
To set expectations right, let me declare that no investor can possibly have a 100% success rate in the stock market. Losses are normal.
But as Mr.H.Jackson Brown Jr. said, “Be willing to lose a battle in order to win the war.”
The Secret
The secret is creating a trading system for yourself where when you lose, you lose small and when you win, you to win big. Using this, you will be profitable over a series of trades.
This is possible by strategically placing the stop loss and profit order.
Stop loss is an order placed with a broker to buy or sell once the stock reaches a certain price. It is meant to limit the loss of an investor.
Profit order is the inverse of stop loss, which puts a limit to the gains of an investor.
For example, if a stock is purchased at $10 and a stop loss of $5 and profit order of $15 is booked, the trading software will automatically sell the stock once it hits this targets of either $5 or $15 respectively.
The Theory
Statistically speaking, the expected return of a portfolio Is:
Expected return = (probability of success)x(profit %) + (probability of loss)x(loss % )
Every investor has his own method of trading that determines his probability of success.
Some of the strategies that have a history of generating at least a 50-60% success rate when used right are as follows (The list is not exhaustive):
1) Bollinger Mean Reversion Strategy.
2) William %R.
3) Swing Trading.
4) Commodity Channel Index.
5) MACD (Moving Average Convergence Divergence)
The Rule
For a stop loss is placed at x% from the current price of the stock, profit should be booked at 1.5x.
Thus, having a risk to reward ratio of at least 1.5
Simply put, for every $1 of risk, we expect to make at least $1.5.
For example,
If You buy a stock at $100 and place a stop loss at 1%,
that is 100 – (1% of 100) = $99
Then, profit target should be 1.5×1% = 1.5%.
Thus, it will be 100 + 7.5% of 100 = $101.5
The Proof
Let’s say you make 20 trades a month,
For a 50% success rate, you will win in 10 trades and lose in 10.
For every win, you get a 1.5% return but for every loss, you lose only 1%.
Thus, your gain is 10×1.5% – 10×1% = 5% per month.
The different scenarios are shown below.
Important Notes:
1) Be willing to risk maximum of 1% of your capital in a single trade.
Example, for a portfolio of $10,000, your maximum loss in a trade must be $100.
2) Follow the same risk to reward ratio in every trade.
At least 1.5 with a recommended maximum of 2.
3) You must not violate the stop loss and profit rules.
It is normal for you to get greedy when the prices are rising above the targets, or be hopeful even after the stock breaches the stop loss.
You might want to play safe and take a small profit before it hits the target, or panic and exit when you see the slightest of losses.
But if you buy and sell at the decided limits, as proved above, you will generate consistent profits in the long run.
The numbers don’t lie!
Author: this is a guest post written by Hriday Goenka
