When taking a trading position we have two different types of risk;
- Information risk - Having less information but getting compensated by a better price.
- Price risk - Having more information but paying a worse price for it.
Whichever one of these best suits you will tend to heavily skew how you look at risks and opportunities in the market. Let's look more into what they mean.
We'll use a hypothetical example of wanting to short a stock in the $100 area. When we decide we want to do this we have a few ways we can go about planning how, when and why we'll get into the trade. We can either opt for aiming to get the best price (Short highest) or to look to get more information to tell us if the trade is likely to work before entering, but often having to short lower.
Let's say we've gotten the reversal level correct and the move is going to form something like this.
Here if we're going for the best price we're going to be shorting around where we think it can turn at 100 and into moves above there within a pre-defined tolerance zone for false breakouts. As soon as you see these bull candles turning to bears you're interested in shorting - especially into the spike moves offering better prices. To short into the best price you'd have to do it with no info to tell you it was working and shorting into the second best price would only have given you small hints.
The alternative to this would be to wait and see what happens when price hits this area. Once price had went above, came back down under, retested 100 and then been pushed away from it an entry could be taken upon the breaking of the lows (First big bear candle after the range/100 retest). At this time you have a lot of info suggesting bears are in the market but you're in at a far lower price.
The middle ground of these is entering on the 100 retest. At this point you've got a bit of info when price can pushed back down under 100 but you still do not know what it will when it gets there again, you're willing to bet that sellers will come in and hold that level. Doing this can never give optimal price but has extra requirements to enter (It cuts out losses by way of more info required to trade).
Here I've marked out the areas from the most aggressive (Best price/least info) to the most conservative (Lots of info/lower price).
Now let's look at the pros and cons of the different trades.
Starting with the one getting the best price. The cost of getting the best price is going to be having frequent losses in the move to the high since you'll be shorting into moves up and if it's not working out you'll want to stop out and short higher at the better price. You'll have an initial losing streak and be compensated by much larger wins.
Entering into the 100 retest or the candle after the rejection from that would give you this type of risk profile.
And our most conservative one looks like this.
In this type of move the most profitable outcome with all else equal is going to be the first one. It will take multiple losses but then pick up entries that are paying 1:10. It can pick up two or three of these and it is not going to cost 20 or 30 different levels to find out if it's working (After 5 it's not!) so whenever this type of move happens it is going to come out on top.
This would also be the most uncomfortable of the three. The other two do not take any realised losses and do not even take that much equity drawdown. There's not the unknowns that are when we're yet to see what price the market is going to make a high from - which is where we'd want our stop loss to be behind.
The conservative version in this one comes out a strong bottom in terms of performance relative to what was risked in the trade. Even if the stop loss was lowered it was only ever going to get 1:2 pay-off. In this type of move this sort of strategy will not do as well as the others, by a long way, but it has it perks when the market does not reverse.
If the market rallies through the level it's usually going to look something like this and the strategy that did best in the reversal will generate multiple losing signals before it breaks through the tolerance zone for a spike out. The middle ground version will pick up one losing signal on the reaction (Which is most probable if you've picked a good level) but the conservative strategy triggers no entry.
Over a large sample size these things for the most part cancel each other out. If you're using the aggressive entries for the best prices in the times you get winning swings you're going to have homerun profits in the times you are not catching a winning swing there will be a lot of small but persistent losses.
When using a middling ground version you're going to get into some really nice entries and have a good pay-off stress free trade. But the price for this is you're going to have the false signals and also you're going to miss some of the big trades that do not come back to test the area you want to enter from.
For the conservative one you're going to have very few losses but typically not be getting high ROI relative to what you can lose if the market was to make a strong rapid move against you. You're looking for the development of a trend and then joining into it. While this is a great thing to do two drawbacks of it are you enter into a trend later and determine it's turned against you later (Meaning you can lose running profits by having wider trailing stops).
The most critical aspect of which one of these suits an individual is their attitude to risk and perception of what is risky. The idea of betting on something where I can be paid a large return for a small bet and looking for places I have the bests to odds to do that dozens of times seems like a low risk proposition. For others this seems like a certainly of losing money in the hope of making it later.
For someone who is very risk seeking they'll tend to find it galling to have thought the market was a short at 110 and end up shorting it from 80 to 60. This seems like missed opportunity. Whereas for others this is a very acceptable trade-off for the higher probability of success and experience of less unknowns/anxiety during the trade.
This is a personal thing and something people have to select best suited to their own personality traits. Very few will be naturally inclined towards both. It's like your writing hand. You'll tend towards one and it will usually become dominant. While it is possible to train both, it's not something that is easy, fast or comfortable to do.
A lot of the arguments people have in trading come down to a fundamental disagreement on these concepts. When one person thinks the other is crazy for buying things at crazy high prices after recent parabolic price increases and the other thinks them crazy for shorting into a market that looks like a runaway train. Usually it's just a difference in the perception of risk and value offered for it.
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