Thread by @i_am_jackis

RISK to REWARD / COST to BENEFIT 📚

🧵 In-depth thread about this phenomenon, that can be used in various aspects of our lives. Not just in trading

This will IMPROVE your life 👇

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Risk to reward, in shortcut RRR or just RR, is an amazing concept that we use every day without even realizing it

But it is exactly that realization, which you will learn here, that will help you identify & use it effectively

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This concept is mainly to realize that everything we do in our lives and every decision we take involves risk/cost

The RR ratio then calculates how much reward there is for such risk

It can also be described mathematically as 0,2:1 / 2:1 / 5:1 and so on

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We understand this in trading a lot but we forget that we also risk when we cross a crosswalk and even on a green light

The chances you gonna cross safely are high but there is still a tiny chance you're gonna get hit by a car regardless

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In such terms, we could say the RR ratio is really high

In life, we don't have time to calculate it each time but we should be able to understand, there is still some risk & our goal is to minimize it as possible at the lowest cost (This is important & more on that later)

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- The basic state is crossing the road -

Here are a few ways to improve the RR

1) Using the crosswalk
2) Crossing on a green light
3) Looking left and right that no car is approaching before crossing
4) Using all of the above

Each of these raises the ratio to our favor

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If the basis state was (random) 500:1 of not getting hit then while doing all the points mentioned above we could've raised the ratio to 50000:1

Important to realize: Even while doing all of those, there is still risk involved and can never be erased, only minimized

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The cost of minimizing the risk

Everything in life costs some scarce resources. While maximizing the RR ratio in our favor we gotta realize it also has costs and then it is up to us to decide how much "cost" we wanna pay for the lower "risk"

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In our example the "cost" of lowering the risk was

1) Finding the crosswalk - energy to get there + time
2) Waiting on a green light - time
3) Looking left and right before crossing - Muscles and time to move the head

We could also add sounds to the equation instead earpods

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It is then up to each individual to decide whether the resources are worth lowering the risk

It will also differ depending on time & place and other factors

Many of these decisions are done in subconscious mind but if you realize them & make them your habit you can benefit

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Also it is very important to understand that each of us has a different risk tolerance

While some will prefer to lower the risk some will prefer to lower the resources & take the higher risk

Hence why there is not 1 single best way to do things but differs for each person

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This understanding should create respect for others towards you & for you to respect others' decisions

If all of us do the world would be a better place

While one can invest in bonds & consider stocks risky, the other can invest in #crypto & consider stocks not interesting

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Now to understand the risk to reward in trading/investing, there is an easy tool to calculate our ratio

We use 3 levels:
1) Entry
2) Invalidation
3) Target

In this example, the ratio was 2,36:1 & 3,4:1

The cost here was the capital used & time during the trade

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Now a small mental game if we use this analogy for our cross-the-road example

We use 3 levels:
1) Entry (Entering the road)
2) Invalidation (Getting hit by a car)
3) Target (Successfully crossing the road without getting hit)

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We also need to measure the probability/ability (cost) of a setup/life situation

In the crosswalk example, it would be your ability to cross the crosswalk and not collapse midway

With crosswalk, it's easy to understand, but how about crossing continents on a small boat 🤔

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In trading/investing, however, not always higher the RR ratio equals a better outcome

We also need to be able to analyze probability where the price can & cannot go and adjust the RRR tool

In example 1, RRR was "only" 2.36 but worked
In example 2, RRR was 17 but failed

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And while traders can use price as invalidation to measure RR, investors can use asset/company & their invalidation is basically the collapse of the given market/firm

Their cost to that trade is time and opportunity cost, should the asset stay in that range for a long time

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A recommended risk on trade/investment is 1-3% of your capital

Again basic principle, higher the risk, higher the reward, and vice versa

If the project has a higher risk, you should risk less, and vice versa

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If an investor sees some asset as an opportunity and his invalidation is basically zero, then he needs to calculate the risk of such asset going to zero or the time it will need to recover

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For example, if you invested in the #DowJones index at the peak of 1929 before The Great Depression and held through the whole drawdown, it essentially took you 15 years of opportunity cost just to get to break even.

With #Nikkei, it has been 33 years and not yet to B/E

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As you can see there is NO RIGHT WAY to do it. Each of the techniques has pros & cons & each suits a different person

Its not that investing is better than trading and vice versa

But the Risk to Reward tool can help us a lot understand the potential risk & costs for reward

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One way to highly mitigate the risk is by diversifying

Across markets/pairs/stocks/countries and so forth

But that has costs too. Like managing so many portfolios

The goal of this thread is to give you the idea of RR and to think about its implications for your life

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As for trading which is my expertise, what I found being the "sweet spot" risk to reward is somewhere around 2-5R

Anything below is not worth the reward, anything above involves too much risk

That said I've seen successful traders with boh higher & lower R

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But more often than not, those who aim for too much, get too little and those who aim for too little, get a bit of nothing

Hindsight RR is nice but for real trading, 2-5 will do it for you

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I hope this thread was helpful to you and that it will help you utilize this great tool in your real life

Remember even a jump into a swimming pool uses this

If you found this thread helpful/insightful, please consider writing a comment below and RT. Thank you for your time 🙌