The chance-risk ratio, often abbreviated to CRV, plays a central role in the trade and you will certainly have encountered it at some point.
Contrary to what may seem obvious, CRV has nothing to do with the likelihood of success for the next trade – at least not directly – but CRV describes how your potential profit from the next trade compares to the risk you take.
Let’s take the following example: You want to buy stock X at the current price of 107.04 euros. You secure this trade with a stop loss of EUR 99.50 and the target for this trade is a price of EUR 135.00. Using these amounts, you can now determine the CRV of this trade by dividing the potential profit by the initial risk.
The potential profit (chance) comes from the difference between your target price and the purchase price:
Chance = 135.00 euro – 107.04 euro = 27.96 euro
Your initial risk is the difference between the cost price and your initial stop loss:
Risk = $ 107.04 – $ 99.50 = $ 7.54
By dividing these two quantities, you now get the CRV for this agreement:
What does this indicator say?
With CRV, you can only see what you expect to win for every euro you risk, as long as your goal is reached. In the example above, you expect to earn 3.71 euros in profit for each risked euro.
That’s fine, but how does it get me anywhere?
Not much in relation to the next trade, because with the CRV you have no idea whether the next trade will be a winner or a loser. But the CRV is an important statement for your long-term success, because as the CRV increases, your chances of winning in the long run increase. It is at least the unanimous tenor in many publications on the subject of trade. The reason for this seems logical, because the bigger your CRV, the more often you can afford to lose.
Let’s say you only enter into agreements with a CRV of at least 3.71 in the future.
Then you could theoretically lose all risk 3.71 times in a row and would only need a profit on the next trade to get to plus-minus zero overall (excluding fees). That means you would not be a loser in the long run with a hit rate of only 22%. Against this background, it is not surprising that one often only reads deals with high CRVs, but it is only them half truth.
Proper handling of CRV
In general, it is only recommended to enter into trades where the CRV is at least 1.5 or 2, and the larger the CRV, the better a trade is said to be.
The problem, however, is that you can only estimate the chance – as opposed to the risk, which is already firmly defined by your fixed stop loss before the start of the trade. However, an estimate makes this metric very vulnerable because it raises the question of how realistic it really is for the stock to reach the target price? This question is DOES NOT can be answered with certainty, but is highly supported by empirical values.
Statistical studies can also be used to determine the chance as accurately as possible. If e.g. a stock has already moved 30% upwards from the low point since the beginning of the year, and you know from a similar analysis that the fluctuation interval within a year was rarely more than 40%, you can use the current option with a Determine a price gain of another 10 %. Central supports or resistors can also be used to determine the possibility.
ONE major problem still exists: Shoppers like to dream! Estimating the odds in a trade can quickly fall victim to mood. If you are hot to shop and / or see a new big bull market just around the corner, then you are quick to overestimate the goals unrealistically high. The same should apply to situations where you have suffered different losses over a long period of time. Again, we tend to overestimate the potential of a trade, especially in combination with the associated probabilities. If we have lost three or four times in a row, then an argument like this is not far off: Now the trend reversal must succeed. How far should the price fall?
The problem with the many resistors / supports
It quickly becomes clear that estimating CRV does not work without a certain amount of ignorance when we look at where the next resistors (supports) can be found.
If we go into a trade long, it seems likely that the price can bridge between the square to the next resistance. However, we usually find the first resistance after our entry only a few cents or euros above it. Feel free to try it once. Take any chart at day level and mark a virtual entry point. Start now with the weekly chart and just plot all the horizontal support and resistance and all the trend lines down to the hourly chart. I’m pretty sure you will no longer see the forest for the trees. If we proceeded in this systematic way, there could be almost no trades where CRV was greater than 1. Therefore, we are forced to use only the “important” resistors and supports for our analysis. We are sorting out and this is another source of error.
CRV and profit – is there a connection?
A basic question is also, does profit increase when CRV increases? The following figure, which shows this correlation based on a strategy with the super trend indicator, allows only one conclusion: you can not generalize the correlations. A high CRV does not necessarily lead to a better result.
The interplay between CRV and probability is crucial to this outcome. Achieving bigger goals is just less likely. The larger our CRV, the less likely it is that this goal will be achieved. This means that there are two opposing effects. CRV has a mathematically positive effect on the surplus in euros, but the resulting declining probability has a negative effect. The key question is: which of the two opposing effects dominates? The figure above shows very clearly that we can not give an overall and generally valid answer in this regard. In this case, the chart should have been steadily increasing (CRV compensates for probability loss) or steadily decreasing (CRV does not compensate for probability loss).
For one or the other, the current analysis of CRV may seem relatively theoretical or at least mathematical. For this reason, however, knowledge of these is no less valuable. In the previous pages, we took a closer look at the risk-reward ratio and asked if this could be the key to success. In any case, this is how it is often expressed, according to the motto: Only traders who bring a large CRV and the profit comes by itself.
That would be nice, but the reality is different. A large CRV has a positive impact on performance, but at the same time leads to a lower probability that this goal will also be achieved. There is only an increase in performance if the performance improvement of the high CRV compensates for the disadvantages of the lower probability. Whether and with which CRVs this is the case cannot be said in general. This is explicitly dependent on the selected input signals & Co. Traditionally, a trade with a CRV of 3 would be rated better than one with a CRV of only 0.6. In reality, however, trading with 0.6 CRV may still be more successful.
Just because we see a 3: 1 potential in the next trade, does not necessarily mean it is a good trading idea. It would be too good to be true, for why should we worry about position size or entry if such a simple rule would lead to a successful strategy across the board. So if you are using the CRV as a trade evaluation benchmark, you should do so in a sensible way. Avoid the above errors and pay attention to the relationship between CRV and probability (hit rate). In addition, always keep in mind the subjectivity with which we value the CRV. Here is another major source of error.
Reading tips: Risk analysis – How to assess your portfolio correctly!
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