Last week I discussed two key values in your trading that could cause you to lose money when trading.
And how fixing the imbalance between these two values could make all the difference.
This week I want to look at exactly what these values are … what can go wrong with them … and how you can put them right.
The two numbers I’m talking about are your win rate and your risk-reward ratio.
Your win rate when trading is simply the number of trades you win, compared to the number of trades you lose.
If you place 100 trades, and had 80 winners and 20 losers, your win rate would be 80%.
If you place 10 trades, and had 4 winners and 6 losers, your win rate would be 40%.
Obviously, we all prefer winning to losing, so a higher win rate is a good thing.
However, win rates alone don’t tell us anything about how much money we can make.
Often traders will brag about their 80 or 90 per cent win rates, but fail to tell you about how much each winning trade makes and (more importantly) how much those few losing trades lose.
And that’s where your risk-reward ratio comes in …
The risk-reward ratio of your trade is a comparison of the amount of money you’re looking to win and the amount of money you’re prepared to risk.
In simplest terms, it’s the distance to your profit target against the distance to your stop loss.
So, if you’re trading with a profit target of 30 points, and a stop loss of 20 points, your risk-reward ratio is 3:2 (i.e. for every £2 you risk, you’re looking to gain £3).
If you’re trading with a profit target of 15 points and a stop loss of 45 points, then your risk-reward ratio is 1:3 (i.e. for every £3 you risk, you’re looking to gain £1).
Again, it seems obvious that a higher ratio is going to be better – we’d all like to win more money, and risk less.
However, much like win rates, risk-reward ratios give very little real information about profitability.
You might have a risk-reward ratio of 5:1 (making £5 for each £1 risked), but if your success rate is just 15% (you only win 15 in 100 trades), you’re not going to make a profit.
Likewise, you could have a low risk-reward ratio of 1:3 (making £1 for a winning trade, and losing £3 for a failed trade), combined with a win rate of 80% – with those kind of numbers, you’re still going to have a profitable edge over the market.
This is why win rates and risk-reward ratios must be looked at together. Too often I hear traders obsessing about one of these figures, oblivious to the damage that their ever-increasing win rate is doing to their risk-reward profile … or how their super-tight stop loss is losing them trade after trade.
So, is it really possible to win bigger … more often … and take risk less doing it?
It’s important to be realistic about win rates and risk profiles. No matter how much we’d like it to be possible, no matter how many technical indicators we use, and how many charts we check – the gods of chance will never allow us to make a high-profit trade with favorable odds.
You can’t walk into a casino and expect to get an 8 to 1 payout by betting “red” on a roulette wheel.
Likewise, if you want to make £2 for every £1 you risk, then you should consider yourself lucky if you win 40% of the time.
If you want to win 75% of the time, then you should be prepared to risk £2 for every £1 you win.
In either of these scenarios, you’re keeping a profitable edge over the market.
However, just because we need to be realistic about our expectations, doesn’t mean that most of us couldn’t do a little work to improve our win rates or our risk-reward ratios …
Boost your win rate
Here are some fixes that can help to aid a flagging win rate …
Look for a pattern in your losing trades. Are they often at the same time of day? Are they focused on one instrument? Is there a technical indicator that could help to filter out some of these trades?
Are you over trading? Should you be focusing only on the best set-ups instead of trying to catch every opportunity??
How’s your portfolio diversification? Are you doubling up on positions by placing similar trades on correlated markets??
Are you paying too much on your spread? A high spread cost will make trades considerably harder to win.?
Look at your risk-reward profile – are your stops too tight for the kind of profits you’re looking to make??
Boost your rewards/minimize your risk
If your rewards are being dwarfed by your risk, the solution is to look for ways that you can cut your losses shorter, while letting your profits run further. Sure – this is easier said than done, but there are a number of techniques that can help you with this.
The first of these techniques to master is using trailing stops, which I discussed in detail here
Another way to improve your profits and reduce your risk in one quick move is to improve your entry level. Every point you wait to enter a trade, your profit is reduced and your risk increased. Are you waiting too long for confirmation? Or would you be better waiting for a pullback to enter your trades??
And finally, are you being disciplined about closing losing trades, or do you sometimes hang on to them, hoping their fortunes will turn around??
Even tiny adjustments to your trading that improve your win rate slightly or boost your reward profile a fragment can, over the long term, have a significant effect on your profits. So, it’s worth spending a little time looking over your past trades to see how you can improve on them.