Strategy Video: Evaluate Whether the Trade is Worth the Return Potential
- Assessing the potential return of a trade or market is just as important - if not more so - than evaluating the risk
- Market level, participation and volume, activity level, seasonal constraints and more can distort returns
- Short-term setups, nearby targets, reasonable risk-reward ratios and preference for risk aversion meet conditions
It has been said by many people and in a number of different ways, but 'I would not take a trade that offered little to no return if it worked out' is suitable wisdom for every market participant. In this environment, the question of expected return is increasingly relevant in the evaluation of new trades. Evaluating the potential (ideal) and expected (reasonable) profit in the risk-reward assessment is more than simply finding a technical level or fundamental cue to attach a target to. A full appreciation of market conditions is necessary for applying reasonable objectives. And, there is a risk of exaggerating our expectations to fit a desire greater returns in these markets.
We have frequently discussed the limitations for further gains on 'risk' benchmarks like the S&P 500. The level of the index is already a hindrance - record highs offer few milestones for speculators or value investors to track out. Yet, beyond the level, the tepid participation (volume) of the market and the divergence with underlying fundamentals (earnings, GDP, etc) creates a weight in the form of doubt. However, the limitations extend beyond just individual indexes or assets. It is a general misalignment for sentiment bearings. Exposure to high risk assets is excessive and the dependency on low volatility - itself linked to monetary policy - creating a fragile backdrop.
Where conditions seem to undermine the returns that align to 'risk on', it is more evenly distributed this week. In other words, efforts to mount a 'risk off' move just as likely struggle to gain traction. That is due to the expected liquidity drain that is common for the month of August as well as the notorious curb on progress that occurs before the US Labor Day weekend. A very low return potential renders most trades unattractive from risk-reward terms. So, should we expect to identify many attractive setups this week in the convergence of seasonal and structural liquidity droughts? We discuss that in today's Strategy Video.
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