Risk, Reward, And The Robot

Oct. 17, 2013

“It is essential to wait for trades with a good risk/reward ratio.”     -Alexander Elder

I wanted to take some time today to talk about the concept of risk/reward because, without a good risk/reward ratio in your trading, you are practically doomed to fail. Having a good system is fine; having a good risk/reward ratio is essential (see quote above).

A good risk/reward ratio means risking a little to make a lot. You might lose $20 on your losing trades but you make $40 on your winners, and that’s how you become a successful  trader.   In fact, according to DailyFX.com, not having a good risk/reward ratio is the “number one mistake” made by traders.

So what is a good risk/reward ratio? DailyFX.com says that “you should always use a minimum 1:1 ratio” (meaning the absolute least you should do is risk $20 to win $20). If you are considering trading for a living, the most important thing you can learn is to always have positive risk/reward ratios on all of your trades. Furthermore, you should…

Excuse me, sir, but that is incorrect.

Not again. Listen, Robot, risk/reward ratios are the most important rule in trading.

Not so, sir. It is something I hear humans say often, but it is clear that holding to an arbitrary risk/reward ratio does not make sense when it comes to trading profitably.

I’m not sure I’m buying it this time, Robot, but go on.

I’d be happy to, sir. Please examine the following trading systems, and tell me which one you would choose:

System 1:  $27,510 profit, -$6,929 drawdown, 43% win rate, 0 losing years since ‘07

System 2:  $33,652 profit, -$4,637 drawdown, 70% win rate, 0 losing years since ‘07

System 3:  $33,070 profit, -$4,812 drawdown, 71% win rate, 0 losing years since ‘07

I’m pretty sure that’s a trick question, Robot, because they all look fairly similar. I guess I would choose System 2, the one with the highest profit and nearly the highest winning percentage.

Interesting choice, sir.  Here are the risk/reward ratios for all three systems:

System 1:  risk/reward is GREATER than 1:1 (average loss $517; average win $935)

System 2:  risk/reward is LESS than 1:1 (average loss $329; average win $194)

System 3: risk/reward is LESS than 1:1 (average loss $532; average win $287)

You chose a System that broke the number one rule of trading, and you would have been quite profitable in doing so. As you can see, sir, it really doesn’t matter what your risk/reward ratio is. You can make money with that ratio being almost anything.

Well, it can’t be anything, Robot. What are you saying?

I’m saying, sir, that the risk/reward ratio is not the thing you should be focusing on. For example, if you risk $100 to win $200, which is recommended, but suffer a huge losing streak that loses your entire account, that excellent risk/reward ratio did not help you at all. I would offer, sir, that risk/reward consideration is entirely irrelevant.

Then what should I be focusing on?

I would focus on the maximum drawdown number because that number determines whether you will lose your account or not. You need to know how much your system loses during its worst losing streak. Once you know that number, you can adjust your betting size accordingly.

Anything else?

Humans can be very emotional, sir. I would highly recommend choosing a system with a high winning percentage. Humans like to win, sir. It makes them perform better. To win a high percentage of the time, however, it is probable that your wins will be smaller than your losses. You need bigger stops to win more often, and that means bigger losing trades. But there is no need to worry. As long as you win a high percentage of the time, you can be quite profitable.

I will look into that, Robot.

Always happy to help, sir.

Disclaimer:
It should not be assumed that the methods, techniques, or indicators presented in these products will be profitable or that they will not result in losses. Past results are not necessarily indicative of future results. Examples presented on these sites are for educational purposes only. These set-ups are not solicitations of any order to buy or sell. The authors, the publisher, and all affiliates assume no responsibility for your trading results. There is a high degree of risk in trading.

HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN INHERENT LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT ACTUALLY BEEN EXECUTED, THE RESULTS MAY HAVE UNDER- OR OVER-COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN.