 Hi everyone, this is Paul Lang for the Stock Swoosh and I'd like to do a quick little training video about return on investment and compared to return on risk or sometimes called reward to risk as the trading community becomes more and more overlapped with intraday traders. A lot of the terms we use are becoming a little ambiguous or outdated or difficult to understand. So I'm going to run through and take a look at these terms and how they apply to you whether you're an investor or a trader. Turning the terms, return on investment, commonly known as ROI, the definition out of the book somewhere is the net profit divided by net assets. My simplified definition is simply the money you make on a position as a percentage of the money needed to execute that position. Let's take a look at typical investor thinking. The traditional investor would buy a thousand shares of a twenty dollar stock for a total investment of twenty thousand dollars. That is what is required in order to control or hold this stock, twenty thousand dollars. It goes up two dollars over the year, the profit is two thousand dollars. That means that this investor may ten percent for the year, which is a ten percent of course ROI return on investment. You can arrive at that number because the profit was two thousand divided by the amount needed which is twenty thousand or of course you can also simplify the math and simply say well it's a twenty dollar stock that went up two dollars and if you didn't change your position throughout the year there would be a ten percent profit as well. That's the return on the investment. In terms of the risk that this trader incurred, for most investors risk meaning how much money could you have lost on this is a very fuzzy term because for many investors the risk is the whole amount. Many investors will never exit a position and even those that define a risk position ahead of time a certain amount that they may lose may never actually honor that amount. So defining this trade in terms of what they made based on what they risk is often very difficult unless this trader has established or this investor has established a record of containing his or her losses to a certain number. If you were to execute the same transaction as an investor using margin you could double your ROI or your return on investment either by shrinking the base amount by half or by doubling your profit. Here's how that works if you buy a thousand shares of a twenty dollar stock you can do that with only ten thousand dollars in the account because using margin to complete the transaction for the other ten thousand dollars most brokerages will offer you a two to one leverage amount so that you can hold positions overnight or as long as you want to holding that two to one amount meaning you only need half of the normal amount that you would to execute the transaction. It goes up two dollars over the year and you make twenty percent for that year this time because either you made two thousand dollars based on your ten thousand amount or if you had the twenty thousand dollar same base account you can now buy forty thousand dollars worth of stock make four thousand dollars and that gives you your twenty percent as well. What is a good return? Well a rate of return in ROI we're generally talking about a passive investor meaning somebody who is taking their money parking it somewhere for a long period of time and seeing how much money is there at the end of that period of time. Currently as I'm speaking banks are offering zero as a round number less than one percent. Bonds and stocks may vary depending upon the quote on quote risk that you're willing to take now risk as I'm using it here I'm not talking about a risk amount there's two there's several uses of the word risk when we trade or invest I'm not talking about the risk amount or the amount that this person has decided to lose before they leave the investment I'm talking about how risky the transaction is in other words if you go to put your money in bonds there are some bonds that pay a very small amount because they're insured by the US government because there's very little chance of losing any of your principal. There are some bonds however that pay substantially more because there is a chance that the smaller city or the foreign country could actually go belly up and not honor their debt obligations and you could lose your money so you can get a very amount of rate of return depending upon the risk that you're willing to take in terms of the chance that you lose your entire investment notice I put cash in here as something that is an investment with a rate of return yes cash can actually make or lose money a lot of people don't look at it that way but it is true in the future if we get into a very high inflationary rate leaving your money as cash could be one of the worst choices because it could lose value more than any other asset possibly that's what happens in high inflationary time so the point being that you have to park your assets somewhere you have to park your money somewhere leaving it as cash is a decision and you can actually look at cash as having a rate of return if you use as your base your actual buying power a little beyond where we needed to be for this but I did want to point out that for long-term investors wherever your money is there is no absolute safe neutral spot trader thinking goes something like this you buy a thousand shares of a twenty dollar stock investment of two to five thousand dollars now how did I get two to five thousand dollars well we talked about as an investor is a ten thousand dollar investment that's needed or ten thousand dollars of capital to maintain that twenty thousand dollar position of stock at a minimum because you get a two to one leverage from the broker as a day trader you typically get four to one from that same type of broker four to one as long as you exit the position during the day because it's more risky for the broker to let somebody hold a position overnight because you have a bigger move so four to one is a typical leverage allotted to day traders which means five thousand dollars is all that you would need to control twenty thousand dollars worth of stock two thousand on the low end because there are things called proprietary trading firms that may give you as much as ten to one leverage some even higher so if the stock was up a dollar on that day you make a thousand dollars on that day and as a trader perhaps you limited your risk to three hundred dollars now a trader is much more likely to have a real significant risk amount that is limited by a number he has preset because to violate that amount on interday transactions that risk amount control really big really quick so we often times will start using the risk amount as being one of the factors that we look at in determining eight traders profitability that means that using the r o i number that we use for an investor the return on investment this particular transaction would have made it from twenty to fifty percent how did i get that well a thousand dollars profit and you could have had as little as two thousand dollars capital needed to execute this transaction in a proprietary trading fund which means you made one thousand out of two thousand of fifty percent return in one day by definition it could have been in thirty minutes that's an incredible number as we'll discuss in a minute there are other important things to consider if you're going to even talk about r o i as a term and for a day trader it's not always meaningful as a trader because number one the base amount the amount of money that's required is what is often changing dramatically that's making a large r o i not the amount you're making in other words if you make that thousand dollars if you needed twenty thousand you made five percent if you need to ten thousand eight ten percent in a prop firm if you need a two thousand eight fifty percent it's not really changing what you made or your trading expertise is simply changing the base amount that you needed because of the leverage that you had so right there r o i become becomes a very difficult term for traders to use also some prop firms actually could require you to put up nothing initially meaning that your return is infinite from the first dollar that you make the second issue is that the i stands for investment in r o i which typically means a passive and lower risk transaction on by lower risk i'm not talking about your risk amount i'm talking about the chances of the entire trade or investment going belly up investor plans on losing their entire investment so with trader thinking we think more along these lines you buy a thousand shares of the twenty dollar stock for an investment of two to five thousand dollars it goes up a dollar that day you make a thousand dollars you limited your risk to three hundred dollars and we typically would say in analyzing the trade that you made three point three times what you risked or your return on risk was three point three to one return on risk is just another way of stating reward to risk which is a term that most traders are well aware of by the way most traders actually use the term backwards a lot of times you recently say well my risk to reward was three point three well they probably mean their reward to risk we almost always turn backers we know we mean though but in this particular example it's a three point three retort reward to risk or you could call a return on risk although that's not as common of a term the transaction may take all day or make ten ten minutes but that's a phenomenal return whatever we look at you can go back and do this trade again and again as a trader and also if you're only using ten percent or twenty percent of your capital you could do ten of these trades at the same time theoretically meaning that the rate of return if you look at it as such on an annualized basis can be typically off the chart for what you can make as an intraday trader there there's a reason for that and that's because you can as a trader typically lose your entire risk amount in other words a winning trade wins whatever you win one times your risk or two times your risk or three times your risk but a losing trade loses a hundred percent of your risk so your overall profitability becomes greatly watered down so while the winning trades look great you say wow triple your money in two hours in one day whatever it is that's great but the end trading results have to include those losses which of course will water down that result and that is exactly what determines the profitability of a trader as a trader we'll typically look to a combination of the reward to risk that we make on average as well as our batting average how often do you lose it all very simply as a trader there's a balance in a trade off if you will between reward to risk and a batting average in other words it's fairly easy to have a very high batting average if you're willing to take a very low reward to risk in other words you get out whenever you have a small profit you can have a very high batting average although your profitability may not be all that great and conversely if you go for really big gains and you go for that big reward to risk number you may achieve it but it may be at the cost of having a lot more trades that stop out on you in order to achieve that big winning trade hope you've enjoyed this little talk about reward to risk return on investment return on risk and it helps you understand the difference as we look at some of these trading terms and may or may not help your actual trading but a lot of these analysis methods are very critical to helping to improve your trading or investing if you are hearing this in a timely manner our next golden gap course is going to be a special event is a live trading event during the trading week tuesday wednesday thursday next week to september twenty seven to twenty ninth so weekday class during market hours will include live trading during the class hours from nine to five if you'd like to sign up or have more questions about the golden gap course you can contact the email at the bottom there that's melissa at the stocks which dot com and if you have any questions about the content of this video feel free to email me up at the top there paul at the stocks which dot com and if you are interested in getting a trial to our trading room you can email info at the stocks which thanks for listening everybody this is paul lang there's another training video out there that talks about share sizing that may also be of interest to you you can find it on youtube if you found this one interesting