If you remember in the Game Planning Program “Risk-Reward, Penthouse or Poor House” we went over why famed investor Ray Dalio will only take trades with a min of 5:1 risk reward or better and for good reason. Below we will go over a few more key concepts that billionaire investors such as Ray Dalio, Kyle Bass and Richard Branson use. Richard Branson a legendary trader? Continue on and you will see why!
- Capping your downside
Capping your downside is the most recurring theme you will hear legendary traders bring up when asked what is most important. Even if you have asked us about a trade idea, usually our first question is ‘Where's your out? What's your risk?’
It's always great when a trade works however we want to be prepared for the worst case. Richard Branson is far from a Wall Street trader, except he looks at business the same way traders look at stocks. Richard Branson’s first question when it comes to investments is, “What's the downside? How can I protect against it?”
When starting Virgin Airlines, which is one of the riskiest sectors to dabble in, he was able to negotiate a deal with Boeing, that if the business failed, he could return the planes. Removing his liability on the debts of some of the most expensive machines known to man. Talk about a risk free trade! This is right around the time he gave us this great quote in a Forbes article:
“How do you become a millionaire in the airline industry? Start with a billion!”
Richard Branson
In every trade, our first goal is to limit as much downside as reasonably possible. We can't put our stop $.05 below our entry or remove all the risk. However, from proper chart reading and understanding how stocks move based off trading psychology, we know that there are certain areas where the trade will fail and that's where we aim to exit if we're wrong. If we’re expecting a breakout and the stock is closing at the lows of days, then we are clearly wrong. Instead of being stubborn, we’ll just return our stock and move on. Same principle that Richard Branson set up with Virgin Airlines had it failed.
- Asymmetrical risk reward
All of the legends above, as well as virtually any successful trader has a focus on asymmetric risk reward. In plain english that means that we aim to make at least 5:1 risk reward, while most new traders aim for 2:1. For a quick exercise, go grab a piece of paper (or just the guide below) and fill out a % ratio you think you would be right in your trades and base it on 2:1, 3:1, 4:1, 5:1, 10:1 risk reward etc.
Let's say that you’re right 40% of the time, and we'll fill out 2 examples. If right you make $2, if wrong you would lose $1 with 2:1, $5 to $1 for 5:1 etc etc.
2:1 5:1
Trade 1 Won +$2 Won +$5
Trade 2 Won +$2 Won +$5
Trade 3 Lost -$1 Lost -$1
Trade 4 Lost -$1 Lost -$1
Trade 5 Lost -$1 Lost -$1
Now based on being right 40% of the time with these two different risk rewards, can you see how a 2:1 risk reward is like swimming with lead weights?
Now 40% is being very generous, as a full time professional trader with over 1,000 trades on average each year, we are usually in the 32-36% bracket. Let's go even lower and let's say that we're only right 20% of the time.
2:1 5:1
Trade 1 Won +$2 Won +$5
Trade 2 Lost -$1 Lost -$1
Trade 3 Lost -$1 Lost -$1
Trade 4 Lost -$1 Lost -$1
Trade 5 Lost -$1 Lost -$1
Most new traders have this air of confidence that we also had, where every trade is going to work because we're smart, right? In the beginning it's usually the exact opposite, 100% right, probably more likely to be 100% wrong. Having the proper risk reward gives you or I a fighting chance.
Want to hear of one of the craziest risk free trades out there from Billionaire Kyle Bass who gave his children a lesson on risk. The trade was in nickels, yes nickels the change you get that you usually toss in the top drawer.
A nickel is what Kyle Bass determined as the only risk free trade ever. You buy a nickel for $.05 and you are immediately up 20% if you “illegally” melt the coin down and sell the raw metal. To prove a point Kyle Bass bought $1,000,000 worth of nickels and put them in his basement, he made $360,000 by doing that.
- Asset Allocation
All the legends above know without a shadow of doubt that they are going to be wrong. We think the same way, we’re not gurus who can predict the future and be right all the time. We know we're going to be wrong and that's why we do so much game planning. Now Asset Allocation dips more into the investing camp and less on the trader who might only have a few positions on. However the same principle applies, even for us when we have 5-6 swing positions on. We are much more confident in our trades and can easily spot which one of those trades is really a dog and needs to be cut. If we only have say, 1 swing on, our eyes are glued to the screen, watching each tick and we are usually far more vested in the idea, which can ultimately hurt us.
Now in the beginning if you don't have that much capital, asset allocation might seem impossible. But it doesn't have to be. If you have $5,000 for example and put $1,000 in each idea instead of going all in on 1 you would be far better off in the long run, since all of your eggs are spread out as best as possible.
Do you have balls?
Share 1 thing you learned from each of the three main points in the lesson.
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