For the longest time, I was focused solely on the percentage gains of any trade. I would look at a stock price and determine how much it would need to run for me to get my desired percentage gain. Usually, I would look for gains of at least 10%, so if a stock was at $8/share, I would want to make $0.80/share, and if it were at $2/share, I would want to make $0.20/share. If I didn’t think a stock could run at least 10%, I would avoid it. After all, high percentage gains are one of the main reasons I love penny stocks. That being said, I don’t only invest in penny stocks, so I account for other scenarios so I don’t miss out on easy trades.
Recently, I have changed my strategy for one main reason; I rarely use all of my cash in one trading day. Percentage gains really do not matter too much if you are not leveraging all of your cash. Additionally, I set my risk exposure based on dollar amounts and not percentage amounts. If my risk exposure for each trade is $200 (it varies for me), that remains constant, and I don’t care if I invest $1000, $2000, or $10,000 on the trade.
This post is not about some revolutionary new trading strategy, but simply a different perspective that may open the doors to more possible trades.
Think about this:
For this example, assume both stocks mentioned below have the same dollar risk/reward ratio of 1:1 with a potential risk of ($0.20)/share and a reward of $0.20/share. Here is how this trade would work when things go as planned.
Scenario A1: You buy 1000 shares of a stock at $8 and it runs to $8.20 where you sell it. You made $200 on an $8000 investment.
Scenario B1: You buy 1000 shares of a stock at $2 and it runs to $2.20 where you sell it. You made $200 on a $2000 investment.
Scenario A yields a 2.5% gain while Scenario B yields a 10% gain. Scenario B is clearly a better trade, BUT they both yield the same return of $200.
Both trades have their advantages and disadvantages. The obvious argument here is that you should compare both trades using the same initial investment.
Sure, let’s do that.
Scenario A2: You buy 1000 shares of a stock at $8 and it runs to $8.20 where you sell it. You made $200 on an $8000 investment.
Scenario B2: You buy 4000 shares of a stock at $2 and it runs to $2.20 where you sell it. You made $800 on a $8000 investment.
Scenario B is looking a lot better now right? Well, yes and no. You forgot that the trade can also go against you. Scenario B may expose you to more risk than Scenario A. Of course, every trade will be different, and it is important to assess risk levels before entering a trade. However, as mentioned above, these stocks have a risk of ($0.20)/share as well.
So, how would the trade work out if it went against you?
Scenario A3: You buy 1000 shares of a stock at $8 and it drops to $7.80 where you sell it. You lost $200 on an $8000 investment.
Scenario B3: You buy 4000 shares of a stock at $2 and it runs to $1.80 where you sell it. You lost $800 on a $8000 investment.
As we saw above, your gains were increased by using the same initial investment on both trades, however, so were your losses. If your maximum risk exposure was $200/trade, you could have never placed the trade in Scenario B because it exposes you to $800 of risk.
What’s the point of all of this?
In no way am I saying that the trade in Scenario B2 is a bad move. I’m just trying to shine light on the fact that percentage gains should not be your only focus. Imagine that one investor takes their portfolio from $1000 to $2000 by the end of the year, while another takes theirs from $20,000 to $25,000. The first investor enjoys an 100% portfolio gain, while the second enjoys a 25% portfolio gain for the year. At the end of the year, the second investor still made more money ($5000 vs. $1000) which is the real bottom line of investing.
Here’s a day trading example. Let’s say your average trade size is $10,000. If you make one trade in the day that yields 10%, you make $1000 for the day. 10% gains are harder to come by so you will be limited in the amount of trades you can find. If you make 10 trades that yield only 2.5% each on $10,000 investments, you can make $2500 for the day. Of course, stocks that run 2.5% intraday are much easier to find than stocks that run 10%.
What You Need to Account For:
1. How much free cash you have in your account – If you have a smaller account, you will want to focus on percentage gains because they will help you grow your portfolio faster. If you have a larger account and don’t use all of your cash every day, it would be wise to consider taking some smaller percentage gains to grow your account. This will be better than just letting your cash sit, especially if you can find low risk trades.
2. Pattern Day Trader Rule – Accounts with less than $25,000 are limited to a maximum of 3 round trips per week (round trip = buying and selling the same security during the same a day) based on SEC guidelines. If you can only make 3 round trips a week, you will want to make them count. You should be focusing on percentage gains because you are limited in the amount of trades you can make.
3. The Time Value of Money – This article is targeted towards day traders who buy and sell stocks within the same day. If you are holding a stock for more than a day, percentage gains are more important because your money is tied up until you sell the particular security.
4. The Dollar Risk/Reward Ratio for a Trade and Your Risk Exposure– This is by far the most important thing to account for. In the above examples (Scenarios A & B), there was an assumption that both trades had the same risk/reward ratio from a dollar gain/loss stance. This will not always be the case. When trading stocks with lower percentage gains, you also want lower risk. This allows you to leverage a higher percentage of your portfolio for the trade. So, in my fictional examples above, both stocks had a risk of ($0.20) and a potential reward of $0.20 (a 1:1 risk/reward ratio). Assuming the amount of shares you bought and the risk/reward ratio were constant, and the price per share varied, this made it so it didn’t matter whether you were investing $2000, $5000, or $10,000 because your risk was always $200 for the trade ($0.20 risk * 1000 shares). The percentage of my portfolio that I invest in a trade is relative to the dollar gain/loss per share, not the percentage gain. This leads to the next important reason why the risk/reward ratio is critical when focusing on percentage gains vs. dollar gains. Let me run through one more quick scenario:
Scenario A: Your portfolio has $50,000 in it. Your maximum risk exposure is $500 per trade. You find a stock trading at $10. The stock has a risk of ($0.10)/share due to a strong support level, and a potential gain of $0.30/share from an intraday bounce. The potential percentage gain is only 3%, yet the potential risk is only 1% for a 1:3 risk/reward ratio. This allows you to leverage a much larger percentage of your portfolio in the trade. In fact, based on your set risk exposure, you could even leverage your entire portfolio (you should never invest your entire portfolio in a trade, but this is a theoretical example). You can now purchase 5000 shares of the stock at $10, for a maximum loss of $500 (your set risk exposure) and a maximum gain of $1500. This fictional stock only has to run 3% for you to make $1500.
Scenario B: Your portfolio has $50,000 in it and your maximum risk exposure is $500 per trade (Kept constant throughout both scenarios). You find a stock trading at $1/share. The stock has a risk of ($0.25) based on a strong support level and a potential gain of $0.50/share due to a positive press release. The potential gain is 50% and the potential loss is 25% for a 1:2 risk/reward ratio. Based on your maximum risk exposure, you can buy 2000 shares at $1 (2000*$0.25/share risk = $500). If the trade goes in your favor, you make $1000. If it goes against you, you lose $500. This stock has to run up 50% for you to make $1000.
Scenario A yields a better dollar gain ($1500 vs. $1000) even though the percentage gain is 47% lower than Scenario B. Of course, you had to use more cash from your portfolio, but as mentioned in the first point on this list, if you have the free cash, you might as well use it. Keep in mind that understanding the real risk/reward levels is critical to the success of this tactic, and, you should always account for the fact that things may not go as planned. A stock’s price action doesn’t follow definitive rules and risk/reward levels may be breached at any time.
How to Use This in Your Trading
As mentioned at the beginning of the article, this is not some revolutionary new trading tactic. It is just a different way to look at day trades. I’m sure many traders already utilize this strategy. Apply this in a way that compliments your current trading style.
By no means do you want to turn this perspective into a strict trading rule. Both percentage gains and dollar gains matter at different times. Personally, I have used this strategy to shift my perspective on trading gains in a way that has opened the doors for more profitable trades. By recognizing that the bottom line of trading/investing is how much money you can bring in, you can look at certain trades in a new light. I look at each new trade based on how much money I think I can make while limiting the position size to account for my set dollar risk exposure. Some traders recommend choosing position sizes based on a percentage of your portfolio (eg: 10% of your portfolio used for each trade). That strategy is solid and helps minimize risk, but it can also limit your trading possibilities. I no longer care how much of my portfolio I leverage as long as I keep my risk exposure constant, nor do I care about my percentage gain on a trade as long as I achieve the dollar gain I desired.