Trading Truth 160

"The markets reward you
for taking greater risks."

The markets do reward you for taking risks. Another way of saying this is that the greater the risk you take, the greater the reward will be if that risk "comes off".

All of this assumes that you are not taking unnecessary risks or being unwise in what you are doing. Unnecessary risks are not likely to be rewarded at all - in fact they will be punished by the markets.

An unnecessary risk can be defined as a risk for which no reward is offered. (Your evaluation will make this clear.)

To take an example:

Suppose you are considering a system which will buy the market (enter long) if today's price goes above the average price of the previous 20 days, plus one average day's price movement.

Let's say that a certain market moves on average 10 points per day, then we will buy if today's price rises above the average of the last 20 days, plus 10 points.

That sounds like a reasonable system.

How could you take a greater risk?

What if you were to dispense with the additional 10 points rule and buy if the market rises above the 20 day average?

You would enter the market earlier, by not waiting for the 10 point addition to occur and you would be getting a price which is 10 points lower. That will be your extra 'return' for taking the extra risk of entering the market earlier.

So, what is the best thing to do then?

The correct question to ask at this point is - what is the best thing to do FOR YOU?

You should answer this question the same way as a professional trader would - and that is by thoroughly evaluating both sets of rules.

You will know your own trading goals - i.e. your goals for % annual return and your risk limit.

After evaluation, if both these systems show they are capable of meeting your goals, then the 'best' one will be the one that has the most favorable risk/return ratio.

However, it could be that the riskier one of the two (dispensing with the 10 point rule) will be beyond your limit for risk - in which case you will discard it.

Without thorough evaluation there is no way of knowing if the riskier of the two systems will show the best return - it all depends on what happens to those extra trades that are allowed when the 10 point rule is dropped.

There is no way of knowing if either of the systems will be acceptable until the evaluation is completed.

There is no doubt you will be rewarded for taking extra risk - when you are right and the risk comes off.

The only way to assess if the extra return is worth the risk is by evaluating the system - but it may be that the extra risk will be ruled out by exceeding your risk limit.

 

Modus Trading
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Copyright David Bromley 2006
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