Risk / Reward Ratio

"Risk and return
are inextricably related."

Whatever you do, you can't escape the connection between risk and reward.

All of us nod wisely in agreement when anyone says that risk and return go hand in hand. But that doesn't mean we are really convinced about it.

We've heard it said many times and we've heard it said by people we respect as being knowledgeable, so we accept it as a fact ourselves.

When you become interested in trading commodities, if you are learning the right way, you will soon see for yourself how true this statement is.

Not only true as a general principle but in the trivial case of waiting one more day before entering a trade, you will see that it will cost you more money to have another day's knowledge.

Of course, you know more about what the market is doing if you wait one more day to find out. You get more certainty, therefore you have reduced your risk by a small amount and so you will get a reduced return in exchange for that.

Let's take an example. You are thinking of buying beans for a long trade.

The price has risen and is now right on your entry signal but you would like to see it break through before you enter the market.

You wait one more day to see if it will break your signal and it does. When you enter the market now, you will be getting a slightly worse price than you would have done yesterday.

You feel more certain about the market and you are taking less risk - but you will get a smaller return on your trade.

What if the price had gone down the next day, moving away from your signal?

In that case you would have decided not to enter the market. You waited for more assurance and you got it - and you didn't take the risk.

But what if you decided that even though the price had fallen, you would still enter the market anyway?

Well, you would now be entering a market which is going against you and this is certainly more risky than the previous day's position before the market fell.

You will get a better (lower) price on your long entry today but of course you know you are taking more risk.

When you trade commodities, you realize that every idea or thought you have can be interpreted as exposing you to greater risk or providing you with more certainty.

When you reckon up the influence this will have on your trades, you will continually be reminded that as you seek a greater return, you must take more risk. Conversely by being more cautious you will get a lower return.

Newcomers to trading must learn that inexperienced traders usually take bigger risks than are justified by the corresponding return. In other words they get a bad deal!

Professional traders minimize the risks they take for their increased returns and get a better deal. They know that the markets never mind charging you too much for your risk.

Successful traders are wise to this and avoid those bad deals whenever possible. They also have ways of tweaking the odds more in their favor.

Risk and return are inextricably related. This needs to be one of the first things new traders learn and understand.

Footnote:

In the everyday world, there are no opportunities to gain rewards that do not involve risk. The greater the reward being offered, the greater the risk you must take to go for it. The same applies in commodity trading.

It is well known that commodity trading can bring very large rewards - that is its main attraction. But commodity trading is inherently very risky too.

Traders can do things to improve their reward opportunity - and things to reduce their risk exposure. These things are incorporated in the techniques they use to 'get an edge' over others in competition with them.

Even so, the axiom remains true and all traders know that they can never hope to get something for nothing. When a trader cashes in a big profit, he feels great - but inwardly he knows things could have turned out differently.

 

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Copyright David Bromley 2006
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