In trading everything is about chance and risk. If you open a trade, you have a chance to lose or win money. The most important question is: How much money do you win in relation to the planned loss? That’s the chance-risk-ratio.
First understand the chance-risk-ratio concept …
To identify low risk entry points you first have to understand the chance-risk-ratio. The concept is simple:
Possible profit / planned loss = chance-risk-ratio.
The possible profit is the money you will win if your trade works as expected. To get this number, you must subtract the target from your entry price. Example: $70 target – 50$ entry price = $20 profit.
The planned loss is the amount of money you are risking. It’s the difference between your entry price and stop loss. Example: $50 entry price – $45 stop loss = $5 planned loss or risk.
Now you have all you need. Here is your chance-risk-ratio:
$20 profit / $5 planned loss = 4.
If your trade reached the target, the return will be 4 times of your initial risk. That’s a good chance-risk-ratio.
Why is the chance-risk-ratio important?
You should only risk money if it’s attractive. Don’t place bets where you only get a small return. Of course it depends on the hit-rate but you want to calculate for the worst case.
If your hit-rate decreases, you need a higher chance-risk-ratio. Because it’s very difficult to maintain a high hit-rate over time, you want to consider this. Try to reach higher chance-risk-ration instead of having a high hit-rate. Then you have build-in a buffer for failure.
What’s a good chance-risk-ratio?
That depends on you and your trading style. If you are a long-term trader, you often have a higher average chance-risk-ratio. If you are a short-term trader, you mostly have a lower average chance-risk-ratio and a higher hit-rate.
The same is true for trading styles. Trend followers often have a high chance-risk-ratio because they are following a trade for a longer time. A swing trader often has a lower chance-risk-ratio because he works with targets.
I personally don’t work with targets. Instead I apply a more trend following style. If a trade will return 3-5 times my initial risk, it’s a good trade. My best trades will return 10-20 times my initial risk.
Paul Tudor Jones famously said, that he will at least aim for a 5 times chance-risk-ratio.
What’s low risk entry point?
It’s simple: The smaller your planned loss or initial risk, the lower is the risk at the entry point.
Don’t think that a trade with a low risk entry point has a smaller risk to fail. That’s nonsense. In the short term every trade has the same odds: 50%. It can be a winner or loser. Only over a large number of trades you will generate a hit-rate and edge.
Focus on trades where you can place a stop loss very close to the entry point. That’s only possible if you select an entry where you see quickly if your trade works or not.
3 examples of different entry points
How to select a valid stop loss level?
I could write a whole own blog post about selecting stop loss levels. But remember: A stop loss level should be your insurance. It should show you clearly that the trade is not working and you have to exit immediately.
I personally only select trades where my stop loss level is less than 7% away. Often I exit a trade or sell a portion of my position at a drop of less than 5%.
If I select a good entry at the right time, the price will never come back to my entry price. Therefore something must be wrong if a stock drops 5-7% after my entry. I give enough room for daily fluctuations but not for corrections!
A simple and clear entry signal and a technical level close to the entry price are important. I mostly use simple chat patterns like flags, triangles or multiple tested resistance lines. For a stop loss I used the last low or a moving average like 10 or 20. That’s it.
If a trade is not working, you can’t do anything. Get out and try it again at a later point. The more important thing is that you have a close stop loss. If the trade is working instead, you have a great chance-risk-ratio.
A low risk entry point needs discipline
If you select a value for your maximum stop loss level, you created a rule. Every rule needs discipline to apply it. If you don’t do that, the rules is worthless.
I personally stick to my rules. I never open a position where the stop loss level is more than 7-10% away. 10% is the maximum I only allow for very volatile stocks. If a stop loss is more than 10% away I skip the trade and wait for a better entry.
A low risk entry will not help you if you don’t have sound rules to select great stocks. You need rules to select potential winners which will generate a good chance-risk-ratio. If you created you rules for a maximum stop loss level, you can start to optimize your selection criteria for stocks. That will increase you hit rate over time.