The Secret of Risk-Free Trading
Trading is inherently a risky business. There is a great amount of uncertainty in how the markets can behave as there are a lot of factors at play. So, is the concept of risk-free trading even possible?
As it turns out it is quite possible, most of the time, by applying a simple mathematical and logical approach to trading based on the understanding of certain commonly seen market characteristics.
It is a fact that the market is generally unpredictable, and the trades placed by even the most experienced traders, more often than not, tend to be correct only 50% of the time. But as we have written about it before one can be highly profitable being right just half of the time if one can achieve a high reward to risk ratio in their trades i.e. when one makes much more when one’s trades are right and loses much less when wrong. And managing this reward:risk ratio with disciplined profit-taking and stop-loss is essentially what the Trading Edge is all about.
While what the market does is something that traders cannot control, managing the reward:risk is definitely something that they do have complete control over. It is just like driving a car: you can’t control what other cars and pedestrians will do but you have complete control of how you react to the driving conditions with the accelerator, brake, and steering wheel. Profit-taking and stop-loss are the equivalents of the accelerator, brake, and steering wheel of the trading world and you can trade safely if you react well with them to the constantly changing market conditions. So, the secret to risk-free trading lies in a simple mathematical and logical use of profit-taking and stop-loss while trading.
A stock rarely moves up or down in a linear manner. This means that even if something delivers a profit it may have gone to the negative side before reverting to turn profitable. Similarly, a loss-making trade may have initially moved to the positive side before reverting to head towards making the loss. Let’s take the scenario of a LONG (buy) trade. A trader would place the LONG trade because there is an expectation that if the trade goes right, it has the potential to generate a larger profit (at least twice) than the risk the trader is willing to take with the stop-loss. And over multiple similar trades, one will be profitable even if say they are correct only half or slightly lesser number of times.
Let’s take an example trade setup where the profit-taking is set at 10% and the stop-loss is set at -5%. This delivers a 2:1 reward:risk ratio. This would generate a net positive return over multiple trades even when trades are correct 50% of the time because the “ secret math formula” holds. But we also know that the market would not move linearly towards either the 10% profit target or the -5% stop-loss. It is likely to go up by about 5% or so before reverting to hit the stop loss. So how do we use this knowledge to try and make our trades risk-free or almost risk-free?
It is actually simple. We just set half of our positions in the trade to take an interim profit equal to the same amount as the risk we are taking with our stop-loss. So, in the above example, we will use half of our positions to take a profit at 5% (or any value closer to it). Now say we have taken that 5% profit and then the trade reverses and drops down to hit our -5% stop loss, the net return would be breakeven at 0%, as we have one-half of the positions delivering a 5% profit and the other half of the positions delivering a -5% loss. But say it continues the upward momentum to hit the 10% profit target, we would have then made a 5% profit with one half of our positions and a 10% profit with the other half resulting in a net 7.5% return from the trade. So, we have essentially made the trade risk-free by removing the loss. Of course, not every trade may go as planned and there could be trades that go wrong from the beginning or those which never even hit the interim profit target but the probability of those are smaller. And so over a large number of trades, we would have achieved, on average, an almost risk-free trade.
The key point here is that there is a lot of control in the hands of the trader to fine-tune their trading using just the profit-taking and stop-loss criteria. Trading consistently in a risk-free way with an effectively managed reward:risk ratio can help anyone achieve a multi-bagger portfolio return.
Identifying the optimal profit-taking and stop-loss for a particular stock in trade, and identifying the strategy that is more likely to work in a certain market condition requires a great deal of data analysis. For traders, it becomes difficult to scale up when doing manual analysis to identify the best opportunities given that there are thousands of stocks and multiple strategies to evaluate for different market conditions. This is why most traders keep their universe of stocks small for analysis and stick to just one or two trading strategies. While even with this there are traders who are able to generate good returns but there are often bigger and better opportunities missed by most. Besides, the market is constantly changing, and things that have worked at certain periods in the past may not be as effective anymore. This is where AI can help traders scale up their trading with the automation needed to process a huge amount of data, and run backtests and simulations continuously to spot the best opportunities on time, for a given market condition.
Researchfin.ai solves this for retail traders and DIY investors. Our app enables anyone to trade like a pro with the help of our AI. Our AI automatically scans, screens, and filters the best opportunities from the thousands of stocks to buy and sell daily. The Researchfin AI analyzes data in an automated way to provide the ideal profit-taking and stop-loss targets for any trade to achieve the best reward to risk ratio a stock can offer. Researchfin aggregates and shows the most relevant information about a stock and its industry, sector, and the market needed to help make better and timely trading decisions. We offer the most advanced investment and trading research technology to the masses at an extremely affordable price.
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