Big Rewards Don't Require Big Risk in Day Trading

Examining the myths of the reward and risk relationship

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Risk management determines risk, not the market. Warchi - Getty Images

There's a prominent myth in the financial world that if you want to make more, you have to take on more risk. This likely stems from the long-term percentage returns of stocks versus bonds. Historically stocks have a higher return but are also more volatility than bonds. Bond offer lower returns, but bonds offer lower historic volatility than stocks. When considering this statement it would seem that you need to risk more to make more, but it's not true.

 

The Mathematical Root of the Myth

When looking at absolute percentages the above 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%. This move also doesn't mean 10% of your capital was at risk, even though the stock moved 10%.

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: $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).

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. 

Instead, assume you place your stop at $29.50, risking $0.50 on each share your own.

Your position size is therefore $500 / $0.05 = 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 (likely not the whole move anyway), because such moves are rare, but the math is the same whether dealing with an asset that moves 0.1% or 15% a day (Find Day Trading Stocks with the Biggest Moves Using These Filters).

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 in order to make it worth their while. This 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. See more in Day Trade Better Using Win Rate and Risk-Reward Ratios.

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 take a trade with very small risk (stop loss close to entry point). By being patient and waiting for such opportunities a larger position size can be taken, and risk is limited no matter how volatile the asset.

If volatile stocks aren't your thing, you can trade calm stocks but still make big returns by trading larger positions (larger position size relative to 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 a something to be aware of. 

Final Word

Avoid thinking in absolutes: "Stock moved 10%, I could have made/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 (closer to entry price). In either case,​ 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--risk is determined and varies on every single trade.