This question is a tricky “hot potato” question that is best answered separately because no real trade gets conducted if we don’t ask it straight. The most profitable trading is between high beta, low beta, and a low beta trade. This is best done over longer term time frames.
Why is this important?
Trading depends mostly on luck, with most investors in our sample, having made only a few trades in their life time. Most people can only make a few trades before losing their money. When you start to trade and you can actually make money, it can be very tempting. We know from the data that the more profitable trades are those under about 80% profit potential risk.
That’s why it’s important to evaluate the long term viability of your ideas before starting a trading career. The short term is where everyone gets all excited.
How do we determine profit potential risk
First, let’s look at a few factors that will determine whether the potential returns on a trade would qualify as “high”:
1) Average profit per trade per trade (A/T) – I’ve written before about this and how it compares to actual future returns (if you aren’t interested: the chart of averages in the graph above is here. We already know from the historical data that for most investments, average trades is far, far, more meaningful than current returns):
The higher the A/T, the more expensive a trade is
2) Average returns per trade (AR/T) – A lot of investor talk about “the market” is the inverse of the above, where the more the average returns decrease the less relevant it becomes as a predictor of returns in the future. In other words, the better an investment market you go to, the lower the AR/T will be
3) Average risk
We saw in the chart of returns per trade above that low returns on an average trade are very rare and only occur in rare situations, but a high A/T is not rare and can be extremely profitable. This also helps explain why so many long term investors have no interest at all in trading.
For example, an investor with a 1.0% A/T risk should be willing to take an A/T of +0.2% per year, which is a high risk trade. An investor with a +0.2% risk should be happy to take +0.3% per year, which is a low risk