Low Trade Risk

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Big Rewards Don’t Require Big Risk in Day Trading

Examining the myths of the reward and risk relationship

Day traders strive to get big rewards without taking on big risks. When it comes to risk and reward, there is a portion of the financial world that believes that if you want higher returns, you have to take on more risk.

This belief likely stems from long-term returns of stocks versus the returns from bonds. Historically stocks have a higher return but are also more volatility than bonds. Bonds offer lower returns, but also offer lower historic volatility than stocks. When considering this risk-reward statement, it would seem that you need more risk more to make more profit, but it’s not true for the day trader.

The Mathematical Root of the Myth

When looking at absolute percentages, the risk-reward assertions seem accurate. Stocks produce higher returns and are more volatile than bonds. But day traders don’t deal in absolute returns or absolute volatility. Just because a stock rises 10% doesn’t mean you made 10% on your account. You could have increased your account capital by 0.1% on the move, or by 50%, depending on your account’s value. This move also doesn’t mean 10% of your capital was at risk, even though the stock moved 10%.

Assume a stock is trading at $30, and you get a signal to buy. You have a $50,000 account and are willing to wager 1% of your equity on the trade or $500. The stock then rises 10% to $33.

How much you make on the trade is not only determined by the volatility of the stock but also how you opt to trade within your 1% tolerance.

If you buy at $30 and place a stop loss at $29.90, your risk on each share is $0.10. Since you can risk $500 on the trade, you buy 5000 shares. This transaction requires leverage because you need $150,000 to complete the transaction—4:1 leverage is common for day traders, so this isn’t an issue. Leverage is the use of capital borrowed from the broker to cover the cost of a transaction.

The price rallies, and you sell your shares for a $3 profit and a $15,000 gain. You’ve netted a 30% return on total account capital.

Instead, assume you place your stop at $29.50, risking $0.50 on each share your own. Your position size is therefore $500 / $0.05 = 1000 shares. You sell your 1000 shares for a profit of $3000 at $33, producing a total return of 6% on account capital.

Day traders aren’t typically going to participate in 10% moves within a day because such moves are rare, but the math is the same whether dealing with an asset that moves 0.1% or 15% a day.

How to Incorporate This Knowledge Into Your Day Trading

Even many experienced traders shy away from volatile assets because they feel they need to risk more to make it worth their while. It isn’t true. By placing a stop loss, you limit the amount of risk you’re willing to expose yourself to. All trading is relative to how much of your account you’re willing to risk, your stop loss level, and the resulting position size.

Traders don’t need to trade volatile stocks or markets, but they don’t need to shy away from them either.

Wait for trading opportunities where you can initiate a trade with a very small risk—with a stop loss set close to the entry point. By being patient and waiting for such opportunities, a larger position size can be taken, and your risk is limited no matter how volatile the asset.

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If volatile stocks aren’t your thing, you can trade calm stocks but you can still make big returns. You do this by trading larger positions—a larger position size relative to the size of your trade when trading volatile stocks. No matter what type of stock or asset you trade, you control your risk, which controls your position size, which puts how much you make in your hands.

Larger position sizes can be harder to exit and cause slippage, so this a something to be aware of.

Final Word

Avoid thinking in absolutes. “Stock moved 10%, I could have made or lost 10%.”. What matters is how each trader establishes their risk and reward parameters, which in turn affects position size.

You can opt to take a smaller position size with a larger stop loss, or a larger position with a smaller stop loss that is closer to entry price. In either case, the risk is controlled, but by being patient and waiting for opportunities where the stop is small—which means a larger position—and the potential reward is big, any asset can be turned into a great trading opportunity.

Historic volatility and returns, while relevant for choosing which markets to trade, shouldn’t be the basis for assessing how much risk or profit potential is involved—the risk is determined and varies on every single trade.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.

The Top 7 Risks of Trading Low-Volume Stocks

A significant percentage of shares are very thinly traded stocks. These stocks trade irregularly or at low volumes. Investors should be aware of the considerable risks of trading in these low-volume stocks. Below, we deal with seven of the top dangers.

There is no need to invest in low-volume stocks. Most investors are better off with ETFs, mutual funds, and large listed companies.

1. Low Liquidity Makes Trading Difficult

One risk of low-volume stocks is that they lack liquidity, which is a crucial consideration for stock traders. Liquidity is the ability to quickly buy or sell a security in the market without a change in price. That means traders should be able to buy and sell a stock which is trading at $25 per share in large amounts, such as 100,000 shares, while still maintaining the price of $25 per share. Low liquidity can also cause problems for smaller investors because it leads to a high bid-ask spread. The average daily trading volume is a good measure of liquidity. As a general rule, frequent traders often lose money when liquidity is low.

2. Challenges in Profit Taking

Lack of trading volume indicates interest from only a few market participants, who can then command a premium for trading such stocks. Even if one is sitting on unrealized gains on these stocks, it may not be possible to take the profits. Suppose that you purchased 10,000 shares of a company at $10 per share one year ago, and then the price rose to $13. Thus, you are sitting on an unrealized profit of 30%. You would like to sell your 10,000 shares and pocket the gains. If the average daily trading volume of this stock is only 100 shares, it will take time to sell 10,000 at the market price. The act of selling your shares may also affect prices in a low-volume stock. Flooding the market with a large supply of the stock can cause prices to fall considerably if the demand remains at a consistently low level.

3. Manipulative Market Makers

Market makers active in low-volume stocks can use low liquidity to profit. They are aware that the stock’s low liquidity means they can take advantage of buyers who are eager to get in and out of the market. For example, a market maker might place a bid for 100 shares near the last sale price and a bid for 1,000 at 10% below that price. If someone naively attempts to sell 1,000 shares at the market price, then they might only get what they expected for the first 100 and get 10% less for the rest. It is necessary to use limit orders for low-volume stocks if you want to avoid these losses.

4. Deteriorating Company Reputation

Although low trading volumes are observed across stocks belonging to all price segments, they are especially common for microcap companies and penny stocks. Many such companies trade on OTC markets, which don’t require them to give investors as much information as firms listed on major stock exchanges. Often, such companies are new and lack proven track records. Low trading volumes may be an indication of a deteriorating company reputation, which will further affect the stock’s returns. It may also be an indication of a relatively new company that has yet to prove its worth.

5. Uncertainty About the Larger Picture

What are the real underlying reasons behind the low trading volume of the stock? Why is there no interest or a wider audience for trading this stock? What is a reasonable price for this stock? Are prices high because someone bought up many shares recently? Or is it the other way around? Are prices low because a big investor dumped shares on the market? Is the company involved in some irregularities that cause its shares to be too risky for most traders? The lack of transparency and difficulty of price discovery make it challenging to see the larger picture for low-volume stocks.

6. Susceptibility to Promotion

Company promoters are best informed about the realistic valuations of a stock. Low trading volumes often lead to temporary periods of artificially inflated prices. That allows promoters to offload their large shareholdings to common investors. Sometimes, this situation can cross the line from perfectly legal self-promotion to illegal pump-and-dump scams.

7. Vulnerability to Marketing Misconduct

Dishonest brokers and salespeople find such low volume stocks an excellent tool to make cold calls with claims of having the insider information on the next so-called tenbagger. Other practices involve issuing fraudulent press releases to lie about prospects for high returns. Many individual investors can fall prey to such practices.

The Bottom Line

The reality is that low-volume stocks are usually not trading for a very good reason—few people want them. Their lack of liquidity makes them hard to sell even if the stock appreciates. They are also susceptible to price manipulation and attractive to scammers. Traders and investors should exercise caution and perform due diligence before purchasing low-volume stocks.

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