I think most traders think about the Reward to Risk ratio, perhaps you think about it. The Reward to Risk ratio may be something that you like to look at – perhaps you will not take a trade if the Reward to Risk ratio is less than 2 to 1. In other words, maybe you will only take trades that offer a $2 reward for every $1 at risk. I completely understand this thinking.
Perhaps you think to yourself:
“If I look to gain $2 for every $1 I risk, I do not need to be correct that often and I can still make money.”
This is true.
But are you likely to stick with a trading systems if 3 out of 5 trades are losers? You can make good money as a trader with a 2:1 Reward to Risk ratio, even if only 40% of your trades are winning trades. Many traders find it difficult to stick with a trading system if most of the trades are losing trades. Perhaps you have a trading system that has an 80% win rate and a 3:1 Reward to Risk ratio. My advice to you would be to trade it and forget everything else. You have a brilliant system.
Unfortunately, most traders will be looking at a 40-50% win rate on a trading system that has a 2:1 Reward to Risk ratio. This means, as my Momma says, “You need to be a good loser.” Most traders I know are not good losers. If you are not a good loser you may gravitate toward a system with a higher win rate (and probably a lower Reward to Risk ratio).
It is important to consider all the factors in your system. The Reward to Risk ratio is one factor. The win rate is another factor. The average win size and the average loss size is also a factor. The Reward to Risk ratio is related to the average win size and average loss size, but trading systems vary – some trading systems use the same stop placement and profit target (e.g., stop is 50 pips away, profit target is 100 pips away). Some systems use trailing exits, which means you never really know where the profit target will be, and other systems have different Reward to Risk ratios on each individual trade because the stop loss and profit targets are based on technical analysis or previous market activity (e.g., profit target at a recent high, profit taken after the moving averages cross, etc).
Here is one factor very few traders think about – the sequence of trades. Sometimes called “luck” or “random noise” – the sequence of winners and losers is also responsible for your trading results.
Will you modify or give up on trading method if you have 9 consecutive losers? If you experience 12 consecutive winning trades will you increase your risk per trade? Remember to consider the sequence of winners and losers in your trading, it is a critical aspect of forex trading. If you start thinking about your random sequence of trades and how you react to it, you are well ahead of 90% of the traders you are competing with for money.
So, in summary, please consider the following five factors when thinking about your forex system:
- Do you know what the Reward to Risk ratio is for your system(s)?
- Is the Reward to Risk ratio always the same for all of your trades?
- Would you be fine with a high Reward to Risk ratio and suffer more losing trades?
- Could you trade a lower Reward to Risk ratio system, but win more often?
- How does the sequence of trades effect your trading?