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 higher return but are also more volatile than bonds. Bonds offer 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.
- 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. But day 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 increased your account capital by 0.1% on the move, or by 50%, 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 then rises 10% to $33.
How much you make on the trade is not only determined by the volatility of the stock but 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 leverage because you need $150,000 to complete the transaction—4:1 leverage is common for day traders, so this isn't an issue.
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 profit and 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 of risk 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.
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.
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 determined and varies on every single trade.