Risk-Reward Ratio At Work
How To Size Up Risk And Reward To Ramp Up Your Returns
In a volatile market like this one, it’s easy for risk, fear, and nerves to take over. While nobody wants downers like that to interrupt their positive emotions and pleasant daydreams, one of the most overlooked aspects of investing is risk - specifically the risk-reward ratio.
So let’s take a look at how you can strike a balance between risk and reward, and maintain your sanity in a market that is almost certifiably insane…
Today’s column is to reinforce investing lessons I learned long ago and give you a training session on the importance of the risk-reward factor. As the following examples show, it’s a pretty powerful lesson…
This Bear Didn’t Just Get Tranquilized… It Was Euthanized
Let’s deal with a very topical example first - the one that had the financial world in a spin on Monday.
As you know by now, Bear Stearns (NYSE: BSC) has collapsed. Having assured the public that everything was okay and it would survive its catastrophic errors, the you-know-what really hit the fan last Friday and into the weekend.
Having traded around $160 a year ago, JP Morgan (NYSE: JPM), with the help of the federal government (who fast-tracked the deal), swooped in to buy the firm for just $2 on Sunday - a 93% discount to its $30 closing price last Friday.
As the stock was plummeting at the end of last week, I looked at selling some out-of-the-money puts. With the stock trading around $35, I considered selling the July 2008 $20 puts. Since BSC had traded in the $70s just a week before, and the Fed wasn’t going to allow the company to fail, it was reasonable that the stock would never see $20 and the premium for selling the puts would be free money.
But as I do with every investment, I thought about the risk if I was wrong. And in Bear’s case, it required extra attention. While I have a pretty good feel of where a stock will head if things turn sour, the truth is that with Bear, I didn’t have a clue. While I thought I was right, I steered clear because I didn’t have a firm grasp of what would happen if I wasn’t.
This reinforces the need to use sell-stops or put options in order to manage losses or protect profits (more on this in a moment). After all, when Bear Stearns was trading in the triple-digits, no one in their wildest dreams could have envisioned this past weekend’s events.
The Right Risk-Reward Helped Avoid This 88% Bomb
Take a look at this chart, showing the last 10 days trading of Keryx Biopharmaceuticals (Nasdaq: KERX). Ouch! That huge 88% drop last week was because of a failed Phase III clinical trial.
I’ve been tracking KERX for a couple of years now. I actually went to school with the CEO and we get together whenever we’re at the same conference. In addition to being a good guy, he’s smart and capable. I’m always very impressed with his presentations to investors.
The early efficacy and safety data on the company’s lead drug, Sulonex, looked compelling. The drug treats diabetic kidney disease and having done some work on the stock, I expected shares to double if the trial data was positive. Subsequent FDA approval would have likely led to further gains.
However, if the data were not positive (as it turned out), the shares would get crushed. The company has a few other drugs in the pipeline, but the KERX story was all about Sulonex.
While I wanted to support my friend, I felt the risk was just too high versus the reward that I expected if I was right. I needed more than a double to offset that much risk.
This risk-reward factor is crucial when making wise investment decisions.
A Suggested Risk-Reward Ratio To Use
When you’re investing, you know you’re going to suffer some losses from time to time. It’s inevitable. But if you’re only grabbing small profits along the way, you’re not being amply rewarded for the amount of risk you’re taking on.
If you don’t want to get stuck in that position, employ this guide that active traders use in order to make a trade worthwhile: A 3:1 ratio of perceived reward to risk. In other words, if an investor is planning to risk $1, he won’t enter the trade unless he believes he can make $3.
Stops And Puts… The Best Way To Clip Risk Without Sacrificing Reward
In our Xcelerated Profits Report investment newsletter, we usually recommend employing a 25% stop-loss on positions. This gives our stocks room to move in a volatile market, but without suffering catastrophic losses if they go against us. That said, we’re not aiming for 10% or even 20% gains… we’re looking for stocks that have potential to grow substantially.
For example, one of my current recommendations is a small biotech company involved in the development of a novel Alzheimer’s treatment. If the drug is as safe and effective as early clinical data indicates, we could have a big winner on our hands.
But what if the risk-reward ratio is negative?
In this case, we’re protected because we bought put options in order to limit our losses. So we still keep the enormous upside, but have used a sophisticated strategy in place to cap our risk.
Why put options and not a stop-loss? In cases like this, a sell-stop doesn’t work as well, because the stocks gap open lower than the stop loss. You’d still sell your position, but at a much lower price than your stop loss.
And if puts had not been available, we wouldn’t have chased after the company, because as you saw with Keryx, negative news could sink the stock. If you’re at all interested, I recommend getting all the details on the position - and the professional way we’re playing it.
So do you want the perfect example of a top-notch risk-reward ratio?
A Weekend Launch
This weekend is a big one for me. I’m launching a brand-new investment service, dedicated to finding the best stocks, based on my five-point F.I.R.S.T. system. As a healthcare specialist, I’m going to be hunting down the best stocks within the sector and judging them on Financials, Interviews (with company executives and other healthcare experts), Research, Safety, and Timing (hence the F.I.R.S.T. acronym).
I’ve already identified a tiny medical device company, currently trading under $5, which could trade north of $100 in a few years. Furthermore, I believe the risk is lower than most healthcare stocks because there doesn’t appear to be any safety issues, as the device is non-invasive. That’s the kind of risk-reward I like. Stay tuned for more details here very shortly.
Bottom line: Investing is all about risk and reward. Be sure you understand both before you pull the trigger and your returns should improve significantly.
Related Article:
–Healthcare Investments: 5 Steps to Investing in Healthcare During a Bad Economy
Loading ...
