Risk is not in and of itself a bad thing.  In fact, it is absolutely vital to trading.  Without risk, there is no reward and, thus, no reason to ever make a trade.  The critical piece to identify is if you are being compensated appropriately for the risk you are taking.  The way to determine this very important question involves two separate analyses:

  • Risk/Reward ratio
  • Expected Value

Risk/reward ratio is very straight forward.  You take a given event, determine what the maximum amount of money you can make, determine the maximum amount you can, lose and then simply divide the two.  That gives you your reward/risk ratio.  What you do with this number is quite subjective.  Is a risk ratio of 1.5:1 acceptable?  How about 5:1?  That is nearly impossible to tell unless you put this reward/risk ratio in context. 

Enter the concept of expected value.  Expected value is simply assigning a probability to a reward/risk ratio (or series of outcomes) to provide the necessary context to make a valid assessment of risk. 

Let’s take the very simple example of a game with a coin.  Step right up!  You pay me $1.00 to play, if heads comes up, you lose, I keep your dollar.  If tails comes up, you win and I pay you $1.50!  So, we can easily compute our reward to risk ratio.  The most we can make is the $1.50 if tails comes up and the most we can lose is the price to play the game of $1.00 which yields a ratio of 1.50/1.00 or 1.5:1.  Is this good?  We can’t know until we put the reward to risk ratio into context.  We have two outcomes, heads or tails, each with an equal probability (50%).  We employ the following equation.

  • Probability of Event “A” x Profit Effect of Event “A” + Probability of Event “B” x Profit Effect of Event “B”+ …
  • Event A = Heads
  • Event B = Tails

Using the above formula, we get:  0.50 x (-1.00) + 0.50 x (1.50) = -0.50 + 0.75 = 0.25. 

Theoretically, anything with a positive expected value is a trade that you could make.  You “expect” the outcome to be in your favor.  The threshold for what is “enough” expected value is purely a personal one.

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