Day traders strive to get big rewards without taking on big risks. When it comes to risk and reward, there is a portion of the financial world that believes that if you want higher returns, you have to take on more risk.
This belief likely stems from long-term returns of stocks versus the returns from bonds. Historically stocks have a higherreturnbut are also more volatile than bonds. Bondsoffer lower returns, but also offer lower historic volatility than stocks. When considering this risk-reward statement, it would seem that you need more risk to make more profit, but it's not true for the day trader.
Key Takeaways
- The standard risk-reward relationship that works in long-term investing doesn't necessarily translate to short-term day trading.
- Day traders use stop loss orders to control the parameters (and risk) of any given trade.
- You can still make big returns on relatively calm stocks by trading in larger positions.
The Mathematical Root of the Myth
When looking at absolute percentages, the risk-reward assertions seem accurate. Stocks produce higher returns and are more volatile than bonds. Butday traders don't deal in absolute returns or absolute volatility. Just because a stock rises 10% doesn't mean you made 10% on your account. You could have increasedyour account capital by 0.1% on the move, or by50%, depending on your account's value. This move also doesn't mean 10% of your capital was at risk, even though the stock moved 10%.
An Example of a Low Risk Trade
Assume a stock is trading at $30, and you get a signal to buy. You have a $50,000 account and are willing to wager 1% of your equity on the trade or $500. The stock thenrises 10%to $33.
How much you make on the trade is not only determined by the volatility of the stockbut also how you opt to trade within your 1% tolerance.
If you buy at $30 and place a stop loss at $29.90,your risk on each share is $0.10. Since you can risk $500 on the trade, you buy 5000 shares. This transaction requires leveragebecause you need $150,000 to complete the transaction—4:1 leverage is common for day traders, so this isn't an issue.
Note
Leverage is the use of capital borrowed from the broker to cover the cost of a transaction.
The price rallies, and you sell your shares for a $3 profitand a $15,000 gain. You've netted a 30% return on total account capital.
An Example of a High Risk Trade
Instead, assume you place your stop at $29.50, risking $0.50 on each share you own. Your position size is therefore $500 / $0.50 = 1000 shares. You sell your 1000 shares for a profit of $3000 at $33, producing a total return of 6% on account capital.
Day traders aren't typically going to participate in 10% moves within a day because such moves are rare, but the math is the same whether dealing with an asset that moves 0.1% or 15% a day.
How to Incorporate This Knowledge Into Your Day Trading
Even many experienced traders shy away from volatile assets because they feel they need to risk more to make it worth their while. It isn't true. By placing a stop loss, you limit the amount ofrisk you're willing to expose yourself to. All trading is relative to how much of your account you're willing to risk, your stop loss level, and the resulting position size.
Note
Traders don't need to trade volatile stocks or markets, but they don't need to shy away from them either.
Wait for trading opportunities where you can initiate a trade with a very small risk—with a stop loss set close to the entry point. By being patient and waiting for such opportunities, a larger position size can be taken, and your risk is limited no matter how volatile the asset.
If volatile stocks aren't your thing, you can trade calm stocks but you can still make big returns. You do this by trading larger positions—a larger position size relative to the size of your trade when trading volatile stocks. No matter what type of stock or asset you trade, you control your risk, which controls your position size, which puts how much you make in your hands.
Note
Larger position sizes can be harder to exit and cause slippage, so this is something to be aware of.
The Bottom Line
Avoid thinking in absolutes. "Stock moved 10%, I could have made or lost 10%." What matters is how each trader establishes their risk and reward parameters, which in turn affects position size.
You can opt to take a smaller position size with a larger stop loss, or a larger position with a smaller stop loss that is closer to entry price. In either case, the risk is controlled, but by being patient and waiting for opportunities where the stop is small—which means a larger position—and the potential reward is big, any asset can be turned into a great trading opportunity.
Historic volatility and returns, while relevant for choosing which markets to trade, shouldn't be the basis for assessing how much risk or profit potential is involved—the risk is determinedand varies on every single trade.
FAQs
The risk/reward ratio doesn't need to be very low to work, though. Trades with ratios below 1.0 are likely to produce better results than those with a risk/reward ratio greater than 1.0. For most day traders, risk/reward ratios typically fall between 1.0 and 0.25.
Is a 1:1 risk to reward ok? ›
Most traders aim to not have a reward:risk ratio of less than 1:1, as otherwise their potential losses would be disproportionately higher than any likely profit, i.e. a high-risk trade.
How do you get a high risk to reward trading strategy? ›
In order to achieve a high reward-to-risk ratio, a trader can either set their target levels very far away from the entry price to increase the reward of the trade, or use stop loss orders that are very close to the entry price to reduce the risk part of the trade.
What is a day trader What are the risks and rewards of day trading? ›
Day trading involves actively buying and selling securities within the same day, trying to capitalize on short-term changes in price. Those involved in day trading often borrow or leverage capital each day in order to purchase additional assets−but it also substantially increases your risk.
What is the secret to successful day trading? ›
Success in day trading requires a deep understanding of market dynamics, the ability to analyze and act on market data quickly, and strict discipline in risk management. The profitability of day trading depends on several factors, including the trader's skill, strategy, and the amount of capital they can invest.
What is the most successful day trading pattern? ›
The best chart patterns for day trading include the triangle, flag, pennant, wedge, and bullish hammer chart patterns.
What is the best risk-reward ratio for scalping? ›
For any stock you plan to scalp, you must understand the price supports, resistances and the set-up. From there, you can calculate the share sizing and the probabilities versus the risk. In scalping, a 3:1 risk to reward ratio is common (although, lower risk/reward is always more favorable).
What is a 50 win rate trading system? ›
Winning 5 out of 10 trades is a 50% win rate. Winning 30 out of 100 is a 30% win rate. Most professional traders have a win rate near 50% or less. They are profitable because they make more on winning trades than they lose on losing trades.
What is the highest risk-reward ratio? ›
To increase your chances of profitability, you want to trade when you have the potential to make 3 times more than you are risking. If you give yourself a 3:1 reward-to-risk ratio, you have a significantly greater chance of ending up profitable in the long run.
What is the most high risk low reward? ›
From a social perspective, a high-risk low-reward is Cheating. The risk of cheating when you are 'happily' married with family/kids is very high because the repurcussion and ultimate consequences is destruction of your family and possibly your career or life, depending on the individual situation.
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- Set Aside Funds. Assess and commit to the amount of capital you're willing to risk on each trade. ...
- Set Aside Time. ...
- Start Small. ...
- Avoid Penny Stocks. ...
- Time Those Trades. ...
- Cut Losses With Limit Orders. ...
- Be Realistic About Profits. ...
- Stay Cool.
What is a high-risk, high-return investment? High-risk investments may offer the chance of higher returns than other investments might produce, but they put your money at higher risk. This means that if things go well, high-risk investments can produce high returns.
How much money do day traders with $10,000 accounts make per day on average? ›
With a $10,000 account, a good day might bring in a five percent gain, which is $500. However, day traders also need to consider fixed costs such as commissions charged by brokers. These commissions can eat into profits, and day traders need to earn enough to overcome these fees [2].
How many hours a day do day traders work? ›
Most independent day traders have short days, working two to five hours per day. Often they will practice making simulated trades for several months before beginning to make live trades.
Can you make 100k day trading? ›
But, those who follow strict trading rules can easily make an income of over $100,000 per year or more. Likewise, the national average salary for day traders who work for a company is $122,724 (source: Glassdoor). You can see below that this average varies based on where you work.
What is the 2% risk in day trading? ›
One popular method is the 2% Rule, which means you never put more than 2% of your account equity at risk (Table 1). For example, if you are trading a $50,000 account, and you choose a risk management stop loss of 2%, you could risk up to $1,000 on any given trade.
Is 1/2 risk reward good? ›
A reasonable risk-to-reward ratio is 1:2, which indicates the profit or reward is higher than the loss. The trader has assured a substantial break-even profit margin when the trading suffers any loss.
What is the best risk reward ratio for scalping? ›
For any stock you plan to scalp, you must understand the price supports, resistances and the set-up. From there, you can calculate the share sizing and the probabilities versus the risk. In scalping, a 3:1 risk to reward ratio is common (although, lower risk/reward is always more favorable).
What is a 1 1 risk reward ratio? ›
1 to 1 risk/reward ratio
This ratio is usually put into practise by more experienced or daring traders, who are willing to risk a higher percentage of capital for a higher potential profit. A risk/reward ratio of 1:1 means that an investor is willing to risk the same amount of capital that they deposit into a position.
