The two ingredients for profitable trading
- Most newbie traders focus on their winning percentage
- Educated traders focus on their risk / reward ratio
- Veteran traders focus on how their payout percentage and risk / reward work together
I work with traders who have a wide variety of skill levels, from newbies to traders who trade their own money (and sometimes that of others) in a professional manner. And it has always interested me how similar the learning process is for most traders. We all start by learning the most basic forex terminology and tools and work our way up until we have defined our own strategy, good or bad.
Something that I often see evolve over time is a trader’s understanding of the payout percentage and risk / reward ratio and the important relationship they have. Today we analyze this crucial concept.
The win percentage error
What if I told you that I have a strategy that has a win percentage over 90%, would you be willing to use it? If you answer âyesâ quickly, you should think a little longer about what a 90% success rate really means. On average, my strategy will win 9 out of 10 times, but how does that translate into real dollars and cents?
The example above is a trap that I see many traders falling into. The winning percentage alone does not create a winning strategy. We also need to know how much the strategy wins and loses on the medium trade to determine if it has an advantage.
In reality, it is easy to create a strategy with a high win rate. We simply set our profit target at 1 pips from our entry and a stop loss at 50 pips. More than 90% of the time our strategy will close trades winning because the profit target is so close to the current price and our stop loss is very far away. No matter where or when we enter the trade, we should still have an excellent win rate.
The problem with this strategy is obvious, however. Our profit per trade is tiny compared to the loss we incur when we are wrong. So, all these profitable trades are completely offset by the rare but important losing trades. We would actually need a success rate of over 98% to be profitable using this strategy, which is almost impossible.
Focus on the risk / reward ratio
Once traders realize that a high win rate is no guarantee that their strategy will be profitable, they often turn to creating a strategy that uses a positive risk / reward ratio. This is good, because it corrects the mistake number one of Forex traders. A positive risk / reward ratio means that we set our profit target above our stop loss. Our reward is therefore greater or the potential risk on each transaction.
Learn Forex: Most traders use a negative risk / reward ratio
(Image copied from DailyFX Traits of Successful Traders Study)
The main advantage of using a positive risk / reward ratio is that it reduces the pressure on the success rate of our strategy. We know for sure that as long as we are right at least 50% of the time, we should be profitable. In fact, our win rate doesn’t have to be that high. We can make money with a payout rate well below 50% if our risk / reward ratio is strong enough.
Combining Success Rate and Risk: Reward Ratio
Bringing these two lessons together is what creates a profitable strategy. We need to have an advantage when we factor in our success rate AND our risk / reward ratio. None of these attributes can make us profitable on their own. The graph below shows several risk: reward ratios and the success rate required to produce equilibrium results. To be profitable, we must have a success rate above the breakeven point next to our preferred risk / reward ratio.
Learn Forex: Risk: Reward Ratio and Required Rate of Return
In my Forex Fast-Track Webinar Series, I commonly use a 1: 2 risk / reward ratio. This means that we need to have a success rate above 33% to be profitable in the long run. Some traders prefer a risk / reward ratio of 1: 3 or 1: 5, this would allow a profitable strategy with an even lower rate of payoff.
Greater than the sum of its parts
Hope these two ingredients got you thinking about your own strategy and how you can improve it. It is the combination of a risk / reward ratio and an appropriate rate of payoff that creates a business advantage, not one or the other of the ingredients alone. If you want to start trading risk-free to test these principles, download a Free Forex Demo Account today with free charts and real-time price data.
— Written by Rob Pasche
Start your Forex trading on the right foot with the Forex Fast-Track Webinar Series. This 4-part live webinar is the fast track for disciplined traders to the Forex market. Topics include:
- Using FXCM’s award-winning trading platform
- Calculate leverage and reduce risk
- Trading with a simple (but effective) trading strategy
- Maintain a Forex account and register for continuing education
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