Wall Street, like Vegas, is a numbers game.
And as much as the odds are on the side of the house, in Vegas, most retail investors lose money trying to battle it out with professional traders who, like the house in Vegas, have several advantages.
Institutional investors have the best technology… they rent servers that are co-located with the exchanges’, so their orders execute faster. And they have highly advanced algorithms.
Professional money managers can afford the best research and data analytics services. And they build whole teams of analysts who work 12-hour days… every single day.
Yet, retail investors can still “beat the house” by adhering to one of the most fundamental principles of this zero-sum numbers game. That is: The reward-to-risk ratio.
This table shows the relationship between two key variables in the investing-for-profits equation.
The first variable is the reward-to-risk ratio. This measures how much money an investor makes on his winning trades, relative to how much he loses on the trades that turn sour.
An investor who has made a large enough sample of trades (say 30 or more) can easily calculate his average reward-to-risk ratio. You simply tally the dollar amount earned on all the winners (and then divide by the number of winning trades). That gives you your average win. Then, you’d do the same for all of your losing trades…
That process will leave you with two values:
- The size of your average win – let’s say it works out to $400.
- And the size of your average loss – let’s say it comes to $150.
The reward-to-risk ratio, in this case, would be 2.6-to-1 ($400 / $150 = 2.6).
And that’s pretty good. Most traders strive for a reward-to-risk ratio of at least 2-to-1, while 3-to-1 is even better.
Generally, a trader with a higher reward-to-risk ratio will do better than a trader with a lower one. That’s because the trader with the higher ratio only has to be right on a small portion of his trades.
This relates to the percentage win rate, the second variable in the profitability equation.
Look at the table above. As you can see, if you earn $1 for every $1 you lose… you’d better be right on 50% of your trades if you want to break even. That’s a tall order, even for professional traders.
Yet, if you can manage to squeeze out $4 in profits for every $1 you incur in losses, you can still survive by losing four out of five trades. That’s right… you only have to have a winner one out of five times if you have a 4-to-1 reward-to-risk ratio.
This principle alone in no way guarantees your success in the markets. Yet, ignoring this principle does ensure you’ll leave Wall Street’s game feeling like you’ve just left Vegas… hung over and poorer.
The house, of course, hopes you’ll play the game without this principle in mind. And it’s my job to help you beat the house…
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