In any type of short term trading one absolutely must be able to quantify risk versus reward. Ho much are you willing to lose on a trade is ground zero for any new trader. If you are day trading it is especially important to know what your risk is. This may mean calculating the difference between your entry price and stop price then dividing your max loss into that number. For instance you enter a stock a $50.10 and will only stay in the stock if it remains above $49.90. If you max loss per trade were, say $100 then you take $100 divided by $0.20 which would allow you to buy 500 shares of that one, particular trade. If it turned out to be a losing trade then you would lose exactly $100 at the exit price of $49.90.
Now, the next question is when do you take your profit? If your risk is $0.20 how much is enough profit? If you risk $0.20 and exit your positions when they show a profit of $0.20 is that a profitable strategy? Do you need to wait until they have only $0.10 worth of profit, or should you wait for $0.40? How is one supposed to know?
Over time you will get a good feel for how many times you win versus how many times you lose. This is a metric you should DEFINITELY be keeping track of. Statistically you will only do as well as 50% winners to 50% losers in the beginning, so let's start there.
Since your dollar risk stays the same but the stop amount changes for each trade we will speak in terms of ratios from here. If you risk 1 ($100 or $0.20 for example) to make 1 ($100 profit or gain of $0.20) you can quickly see that this is a losing strategy. It is not break even it is a losing strategy. Though your gross P&L will be even, commissions and costs will pull you into the red. So right from the start we know that you either need to win more than 50% of the time or you need to win MORE money 50% of the time.
What if you risked 1 to make 2? You only look for trades that you feel can reward you twice what you risk. If you won 50% of the time you would (assuming $100 risk), you would end up with $1,000 in profits, to $500 in losses. A $500 net profit out of 10 trades. Now go a step further and say you were a pretty poor trader and only won 40% of the time. If you still won 2 for every 1 you risked then you would end up with $800 in profits to $600 in losses. That's still profitable and you are only right 4 out of 10 times!
Some of the best traders I know trade once or twice a day but they wait for the moment they feel they can risk 1 to make 3. In this case they can be successful less than 30% of the time and still be profitable. Imagine if you waited for trades that paid 3 to 1, and you could do this 50% of the time!
