The Probability / Reward Trade-Off

One of the many things to consider in outlining a trading strategy is how you’ll address the trade-off between  probability and potential reward. In general, the higher the probability a trade is, the lower the potential reward. For example, if you attempt to anticipate moves, your potential reward will be higher than if you waited for confirmation, at the expense of having a lower probability. Some people are comfortable with that trade-off, while others are not. I’ll try to discuss below the three main scenarios I observe most commonly and briefly explain how I like to handle this “dilemma” in my own analysis.

Anticipating Breakouts / Breakdowns: 

Some traders like to buy or sell in anticipation of a stock breaking out or down. This gives them the advantage of a lower cost basis and more upside if / when it breaks out/down, but not without accepting the risk that the stock does not break in the direction they originally thought it would.

For example, LNKD’s recent action looked like a bullish consolidation pattern as it held a gap higher above the 2013 highs. An aggressive trader looking to anticipate this move might enter the trade with a stop somewhere below the recent lows, expecting to have a lower cost basis in the stock when it moves higher, thus increasing his/her reward. Although the probability of a breakout in the direction of the underlying trend is high, the probability of success for the trade overall is lower than if the trader waited for a breakout.

Probability Reward Tradeoff Image 1

What ultimately occurred in LNKD is a great example of the additional risk associated with trying to anticipate moves. LNKD failed to breakout to the upside and ultimately broke down into the gap, making the long trade the trader put on a losing one.

Probability Reward Tradeoff Image 2

Waiting For Confirmation:

Traders looking for a higher probability trade will most likely wait for confirmation by entering after a stock has already broken out or down. They are willing to accept a lower reward due to their higher cost basis, but are comfortable entering the trade after the market has confirmed that the idea is already working/in motion.

A good example of this is the Dollar Index a few weeks ago. Prices were clearly in an uptrend and began consolidating in late January. Rather than purchase it and hope it breaks higher, a trader in this situation might wait for a breakout and bullish engulfing candle on February 26th before getting involved. Sure, the trader would have to pay higher prices to get involved, but the probability of success for the overall trade is much greater.

Probability Reward Tradeoff Image 3

As we can see from the next chart from the week or two following that breakout, prices continued higher and tacked on another 3-4% move from that breakout. The trader was still able to capitalize on this setup without having to take on the excess risk associated with anticipating the next directional move in this market.

Probability Reward Tradeoff Image 4

Hybrid Method:

What some traders might decide to do is buy a portion of a position in anticipation of the move and add to it on confirmation of a move in the direction they were anticipating. This is a great way to lower your cost basis in a trade and fully capitalize on it after the market confirms your original thesis. If you’re willing to accept the risk that the consolidation you’re buying might resolve itself in the opposite direction you had hoped for and can take the loss quickly, then this can be a good tool for managing your entries.

An example of this in action would be USD/CAD a few weeks ago. With the currency pair in a structural and tactical uptrend, prices took a bit of a pause and formed a symmetrical triangle. Normally, this is a continuation pattern so a trader betting on further upside could buy a portion of the position as price consolidates in this area and would be adding to it on a break and close above this downtrend line. If prices broke down out of this consolidation, the trader would need to take losses because clearly the pair did not resolve itself in the direction he/she originally anticipated.

Probability Reward Tradeoff Image 5

My View:

Personally, I tend to favor the higher probability trades, therefore I normally wait for confirmation before getting involved in most scenarios. Occasionally if the majority of the five factors I look at when analyzing a security line up at once, I may use the hybrid method, but for the most part I tend to wait for price to confirm my thesis before entering.

As always, if you have any questions feel free to reach out and I’ll get back to you as soon as I can.