placed too far away from the entry price to be reached within a day. Let’s say we
use a 2 percent stop, also equal to a 2-point move for a stock trading at $100 (1
point for a $50 stock, 1.5 points for a $75 stock, and 0.5 points for a $25 stock,
but because this trader didn’t believe in percentages these numbers don’t apply).
Buying $100,000 worth of a $100 stock means we can buy 1,000 shares.
Therefore, if the trade goes against us, we lose $2,000 every other trade. To make
$4,000 on average over two trades, the winning trade must generate a profit of
$10,000 (4,000 * 2 2,000), or $10 per share, which also equals a 10 percent
move and a 10 percent return on account.
(Note that if the trading ended at that value for the day, the profit would have
been $8,000 for that day. But because both winning days and losing days occur, we
still need to assume that we must make $4,000 on average, per trade. For example,
if the next day were to end in a loss of $2,000, the average profit per day would
now be down to $3,000 [(8,000 2,000) / 2], and we would have to make $6,000
to compensate for that the following day [(8,000 2,000 6,000) / 3]).
First, how often do you see a $100 stock make a 10-point move over a day,
not to mention an even lower priced stock? And how often have you identified it
beforehand, so that you actually had a chance to ride the move? Once or twice
maybe, but not often enough to come even close to make any $4,000 a day. Second,
with the winning trade having to be worth $10,000 to compensate for the $2,000
loss, to make an average profit per trade of $4,000, the profit factor has to be five
(10,000 / 2,000). Third, making $8,000 while risking $4,000 (2 * 2,000), the risk
factor comes out to two, or a 200 percent return on the risked amount. Knowing
what we now know about the profit and risk factors, how likely is it, do you think,
that we will be able to sustain these numbers, day in and day out, over the next sev-
eral days and months? Not likely at all, I say.
Obviously then, we need to adjust our strategy somehow. Let’s say we adjust
our stop loss to only one point per share, but because of this, the percent of prof-
itable trades decreases to 33 percent, or only every third trade will be a winner.
Now, to make $4,000 on average per trade over three trades, the winner needs to
be $14,000 (4,000 * 3 1,000 * 2). Now the winning trade needs to be even larg-
er, so obviously this is not the way to go, even though we don’t need to find as
many winners as before.
What happens if we go the other way around? Let’s say we set the stop four
points away, so that the percentage of profitable trades increases to 67 percent. In
that case, two winning trades will have to make up for one $4,000 loss, plus an
additional $12,000 profit to make the profit per trade equal to $4,000 (4000 * 3
4000), which means that the profit per trade for the profitable trades needs to be
for $8,000 each. OK, with a total profit of $16,000 and a total loss of $4,000, we’re
down to a profit factor of four and a risk factor of one (12,000 / 12,000).
Obviously, even these numbers are too high to be sustainable, but the only
way to lower them further would be to increase the percentage of profitable tradesCHAPTER 4 Risk 53