Monday 18 February 2013

Risk Reward Ratio

Readers sometimes ask me why am I more in cash and less in the market.
My answer is that it always has to do with the "Risk Reward Ratio".
Take the current situation for e.g. When the media and ZH was screaming danger in last December (ZH is always screaming wolf anyway) I was telling readers to get bullish. We were long for the whole month of January and went to cash when SPX moved close to our price target of 1510. And for the last 3 weeks we have turned patient bear and yet not shorted the market. The reason we are not being long equities here can be explained in the following long term (monthly) SPX chart.

Assuming SPX keeps going up as everyone in Wall St and all talking heads in CNBC are saying, the upside in my view is limited to 1550 which is 2% up from here. It may take another 2 weeks and market does not correct, just to kill all the bears.
But on the other hand, should there be a correction (Not the end of the world, mind you) the long term support is a 1300 level, if 1400 does not hold. At 1400, that is 8% correction and at 1300, that is 15% correction.  So at best we have 8% / 2% = $ 4 risk and at worst 15% /2% = $7.5 risk. In other word, to go long here hoping to make $ 1, we will be risking $ 4 to $ 7.5. Is it worth it?
Just to break even on risk reward ratio, we need another 8% upside from here which is 1641 in SPX. I think that is bit far fetched. And although Ben has promised unlimited money, let us see what happens with the Sequestration thingy coming up in March.

Mind you, I am not suggesting that the world as we know it, is about to end. Simply because I do not know how economy works and what will be the unintended consequences. I just know how not to take unnecessary risk or at least I try not to.

 But I get the feeling that I am in that Jeep and the Volcano has already exploded and all the ash is bearing down. So better run or be in cash to take advantage of a better entry later.
Now you know why I am in Cash.


  1. Very good post. I read your blog regularly and agree with you about...let's see, 99% of the time.

    Traders and wannabe short term traders are always itching to make a trade, even when the risk/reward ratio sucks. It's so hard for many to just sit on their hands and do NOTHING! From experience, developing patience is one of the true skills of a good trader/investor.

    Good stuff WoF!


    1. Thank you Koreaninvestor. Developing patience is the single biggest thing to be successful in trading and I hope readers realize and appreciate that.
      I would consider mission accomplished if I could help others with that.

  2. Hy!
    allow me to say that I'm just in the same situation as you are-in cash! (with almost the same target ...somewhere around 1550...1590 as maximum before "the volcano explosion").
    And although I didn't calculated the Risk/Reward ratio in numbers, the last 3-4 weeks I've had exactly the same view as you ...but let's say it was only intuition. Something like an inner voice telling me that this market is really not tradeable in an efficient way and I should wait. I want to mention that I have a trading experience of only 6 months.
    Thank you. Your post really cleared my mind and brought a clear view!

    V.(from Romania).

    1. Its great that you got the concept correct so early. Keep it up.