My thoughts on why we should aim for smaller reward

Trading Discussion
1

This is a fairly advanced topic, so be warned!

I spent today musing on whether we should aim for a small reward vs a big reward in our trades. My preference has been on taking small rewards (generally between 1R and 2R). I find that it feels worse watching a profitable trade turn into a loser, than it is watching a trade continue on without you once you take profit.

But is there a mathematical reason why we should aim for small rewards?

Here’s a hypothetical situation. We have System A which aims for a small reward of 1R, with a win probability of 67%. It’s profit factor is (10.67) / (10.33) = 2.

We also have system B, with a win probability of 50%. It’s profit factor is (20.5) / (10.5) = 2.

Both profit factors are the same, so at first glance, you’d think System A is just as good as System B.

But lets zoom in to a live trade.

Suppose we go long. We know there’s a 67% chance of hitting 1R profit, and 50% chance of hitting 2R profit.


Price moves in our favour and hits 1R. Suppose we were aiming for profit of 2R.

Once price hits 1R, our risk is doubled to 2R (1R is from our stop loss, the other 1R is from the profit we’ve won so far, which would be money in our pocket if we close the trade). Meanwhile, the amount of profit left to win is 1R.


We are now risking 2R to win 1R. And we know that we only have a 50% chance of hitting that additional 1R. What is our profit factor now? It is (10.5) / (20.5) = 0.5.

Our profit factor is now less than 1. Any profit factor less than 1 means we are actually losing money. We would actually be better off aiming for 1R.

Does this make sense? Are any assumptions wrong?

2

Your assumption of risk becoming 2R is incorrect, the risk remains 1R the whole time. Giving back paper profits is not the same as losing money.

3

Surely you would move your stop loss to lock in your profit and reduce your risk?

4

Hmmm, how could I put it differently. ‘Paper profit’ can be classified as an asset. It can be turned into cash right now if you want it. So to me, ‘paper profit’ is an asset that is at risk until the trade is closed.

5

+1 on that. I use SL to protect my profits and close profitable trades. I think it is vital to secure profits and one of the worst things is to turn your profits into a loss due to lack of trade management.

6

I understand what you mean, but the concept of R as in Risk means that the total risk is always 1R and can be no more since this is the original stop loss placed on the trade. Only if price would be slippaged past the stop loss or if you manually move it could the risk become larger than the initial 1R. The paper profit is just that, profit and not risk.

To always go for 1R profit and not chase the less common but so profitable runner trades has been proved over and over to be an unwise approach. For trend traders such as me we know it’s a fact that it will be the runners that produce the big profits and to cut them out would be the same as turning off what makes the whole trading approach profitable.