Setting cut loss position using Profit/Loss ratio.
Let P = a probability that a trading gain profits.
So the probability that the trading loss is 1 – P.
Let E =an average capital gain
and L = an average capital loss
The overall profit ( OP ) = ( P x E ) – ( ( 1 – P ) x L ) ………(0)
Now the overall profit equation is deal with three variable.
If OP > 0 ===> we can survive in the cruel market. ………. (1)
If OP <= 0 ====> It is a time to adjust our trading decision. ….(2)
It sure that we need to stay survive in the market so we focus on (1)
OP > 0
( PE ) – ( ( 1 – P )L ) > 0 …….. from (0)
Assume that we can control that E = 3L
average profit is equal to three time the average loss
3PL – L + PL > 0
4PL – L > 0
4P – 1 > 0 *
4P > 1
P > 1/4 …………….(4)
From (4), we can see that if we can control the average gain to three time of the average lost, the probability that we buy a right stock = 0.25 is enough to be survive in the market.
Now, the new question is how to control the average gain/lost.
If a stock A’s price is 100
We expect that the price should be 130 ( from fundamental or technical or whatever )
So the maximum profit = 30
Then we set the cut lost point to 10 point ( E = 3L )
The cut lost point is 100 – 10 = 90
The last thing to do is make our probability to buy a right stock to be more than 25%. Is it so hard?
* because L is always a positive number so we divide both side of the inequality equality