What would you think if I told you I lost money on 70 percent of my trades?
Would you scoff at my trading performance? Would you think I’m a bad
trader? Or would you be interested in knowing how much I made on the 30
percent of trades on which I made money? Traders tend to focus on winning
and taking profits because nobody likes to lose money and everybody
likes to talk about wins. Winning isn’t everything in trading, as you’ll soon
find out. Your winning percentage is not as important as your average win
versus your average loss. If you continue to take profits early, you could
hurt the ratio between average win and average loss and ultimately affect
your profitability. The tool used to help increase your average win versus
your average loss is a ratio known as the risk-to-reward ratio, and its
proper use along with position sizing will go a long way to raising your
overall success as a trader. The mistake many traders make is not sticking
to their plan once they have planned a trade with a proper risk-to-reward
ratio.
Traders are traditionally taught that they should strive for a risk-toreward
ratio of at least 2:1 on every trade. In other words, each trade
should earn two pips for every one pip risked. In a perfect world the 2:1
risk-to-reward ratio allows a trader to lose 50 percent of her trades and
still be profitable. The problem, of course, is that trading is rarely a perfect
world. Trades can be cut short of their profit targets when using a trailing
stop, the market could miss a profit target by only a few pips before
suddenly moving against you, and traders often lack the discipline necessary
to remain steadfast until their profit target is hit and they close their
trades prematurely. This is why I like to refer to the risk-to-reward ratio as a
risk-to-potential ratio instead. If you head into every trade knowing thatthe potential is there to mathematically cover your losses, hopefully you
will learn to stick to each trade and stop meddling with them. Overall,
striving for a large risk-to-reward ratio can help you improve your trading
results and should be a part of your risk management plan.
Go Big or Don’t Bother
Since risk-to-reward ratios are not a perfect science, my advice to you
when you’re planning a trade using risk-to-reward as a guide is to go big
or don’t trade at all. Planning a trade with anything less than a 1:4 risk-toreward
ratio doesn’t make any sense to me. Trades do not always reach
their profit targets, and if you are unable to make a profit on every trade,
using a lower ratio won’t help cover your losses if your winning percentage
is less than 50 percent. Waiting for trades that offer you the largest
potential reward for the least amount of risk will help ensure a profitable
result, even if the trade doesn’t reach its profit target. It is better to get a
risk-to-reward ratio of 1:2 on a trade you tried to get 1:5 on than it is to get
a breakeven result on a trade you tried to get 1:2. Do you understand the
difference? Over the long run, traders who wait for the big trades and stick
to their stops and profit targets will do better than traders taking any little
trade that comes their way.
Figure 4.4 illustrates a trade planned using good risk-to-reward. In this
example, a trader bought USD/CAD during a pullback within an uptrend
on support and used Fibonacci to identify a profit target. This trade ultimately
offered a risk-to-reward ratio of 1:5. The example trade in Figure
4.4 also illustrates how a trailing stop loss isn’t necessarily the best
thing to use. If the trader did not use a limit order on his profit target
but trailed it with a two-day low stop loss, the trade would have been cut
short three days prior to the market rallying through the intended profit
target. Shooting for a risk-to-reward ratio of at least 1:4 on each trade will
allow you to lose more than 50 percent of the time and still be a profitable
trader.
The Numbers Don’t Lie
At the end of the trading day, the only thing that matters is whether you
have made money or lost money. Even if you plan each trade with a high
risk-to-reward ratio, it doesn’t mean that you will automatically be a profitable
trader. You must have the courage to hold each trade through to
the end and realize each profit target. This means that you may have to
watch a profitable trade give back its gains before the market reaches your
profit target. You might even have to sweat a little while a trade that was
once profitable dips into negative territory before moving on to your profit
target. This is where many traders fail to hold ranks with the disciplined
traders and start using breakeven stops or trailing stops. They can’t stand
the idea of losing on a trade that was once profitable, but you have to look
at the big picture to understand why that could in fact be good money
management.
If you start cutting your trades short, you won’t realize the profit target
you planned, and that changes your trading performance’s average riskto-
reward ratio. Each time you cut a trade short, you must increase your
winning percentage to compensate for the loss in profit. The higher your
required winning percentage, the harder it will be to maintain a profitable
trading record, as illustrated in Table 4.6.
The example data in Table 4.6 demonstrates how trader number 3
had to be 60 percent more accurate than trader number 1 to make the
same amount in profit. If the third trader’s winning percentage drops to
50 percent, he will break even over 10 trades; anything less than 50 percent
will result in a loss. Unfortunately, maintaining a 90 percent success ratio
month after month can be extremely difficult to do, but trader number 3 has
left himself with no other choice but to be right, because he is not making
more per trade than he is risking. Cutting your trades short, either through
trailing stops or a lack of discipline to stick it through to your profit target,
has a dramatic effect on your profitability.
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