A profit vs loss ratio is something that can by itself help you succeed investing in the stock market. They work wonders for new traders, and are used by professionals as well.
This article will explain what a profit vs loss ratio is, how to set one up, and how to stay disciplined to utilize it effectively.
What They Are
A profit vs loss ratio is a plan that you put in place to limit your downside exposure on all your trades to x%, while setting a target on your upside to x% return per trade. Depending on how you setup your ratio, you can be wrong more than you are right and still make money in your portfolio.
The whole point of your profit vs loss ratio is to be able to say, "hey, even if I am wrong x times in a row and then am right once, I still am making money".
How to Setup Your Ratio
There are 2 factors to any ratio: maximum loss % per trade, and your target profit % per trade. Once you know these you know your ratio.
The best ratio and one that is recommended by CANSLIM founder William O'Neil ( read his books) is to utilize a 3 to 1 profit vs. loss ratio. This means that we can be wrong twice, then be right once, and still make a profit.
So, let's use the CANSLIM philosophy and say that we want to cut our losses to a maximum of 7 or 8 percent each trade. To do this, when we buy our position we immediately place a stop loss order 7 or 8% below our purchase price. If the stock hits this price, the position is sold out and we walk away with our loss. On the upside we will sell any stock after it is up between 20 - 25 %.
Let's see how a few trades would play out (numbers are rounded for simplicity):
You buy 100 shares of a $20 stock, so $2000 total...
but it goes down 7% (-$140)...
to $18.60, and you sell leaving you now $1860 left to trade.
You buy 100 shares of a $18.60 stock, so $1860 total...
but it too goes down 7% (-$130)...
to $17.30, and you sell leaving you now $1730 left to trade.
You buy 100 shares of a $17.30 stock, so $1730 total...
and it goes up 20% (+$346)...
to $20.76, and you sell leaving you with $2076 total.
Even though you lost twice in a row, you still made money overall in your portfolio. With a 3 to 1 profit vs. loss ratio we in a sense have a .333 batting average and still are successful traders.
Maintaining Your Plan
This is the most important part. So, let's say you want to implement the CANSLIM 3 to 1 profit vs loss ratio, you have to write it down and STICK WITH IT.
How do you do this? You use stop loss orders to always minimize your losses, and you ALWAYS sell 20 - 25% above your purchase price. If you want your runner to run longer, then once you are up to your target price move your stop order up to lock in your gains.
The bottom line
It is a fact that some of the best traders in the world are only right in the stock market less than half the time. By staying disciplined and using a good profit vs loss ratio though they still make money consistently in the stock market. Great traders know how to strategically invest, they use a profit vs loss ratio.