The Terrible Danger of a Good Risk to Reward Ratio

July 18th, 2018

Everybody knows there’s no Holy Grail in trading.

Except, of course, that there is.

While there may not be a system that qualifies as the Holy Grail (debatable), smart people will tell you that a concept is Grail-like.

And that concept is risk to reward.

Just recently, I listened to a webinar that told us that very thing.

In the webinar, many different systems were discussed. The point was: the system we choose isn’t that important.

What was truly important, they said, is that our reward must be much larger than our risk.

The key to being a successful trader is having profits that are 2-10 times larger than the amount of our stoploss. That way, even if the win rate is only 50%, our profits will always outweigh our losses.

Risk to reward is the key to everything. It’s the Holy Grail.

Great. All our problems are solved.

We just need a system that wins 50% or more and has profits, say, 2-3 times larger than our losses. No problem.

Except there’s a problem.

There’s a huge danger to having a “good” risk to reward ratio.

The first problem is the winning percentage itself.

To trade a system with a reward far outpacing the risk, the truth is that the win percentage isn’t going to be 50%. It’s most likely going to be a lot lower.

Typically “good” risk to reward systems have win percentages that drop down into the 25% range.

Yikes.

Do you know what it’s like to trade a system that wins about 25% of the time? Have you ever tried it?

It’s not great.

If we win 25% of the time, that means we lose 75% of the time. That’s a lot of losing. That means almost every day of our trading life is going to be spent looking at our accounts going down.

And when we go on losing streaks (streaks of small loss after small loss), it can get pretty depressing pretty fast.

And when it gets depressing, it’s easy to think we’ll never get a winner again.

And if we feel like the winner will never come, we might feel like quitting on this loser of a system.

Which means, of course, that we’ll miss the next big winning trade.

Which means, bringing it back full circle, we get the nasty combination of a low winning percentage and profits that aren’t bigger than our losses (because we just missed the huge winner).

That’s a losing proposition.

There’s another sneaky problem to seeking the magical risk to reward.

If we believe what the experts tell us, then we won’t accept anything less than our winners being bigger than our losers.

By accepting that concept as law, we might actually be guaranteeing we’ll never be successful.

Here’s the thing, risk to reward isn’t the Holy Grail. There are many systems that work WAY better with a “bad” risk to reward ratio.

For example, remember our little indicator experiment on the ES? Remember how we put basic indicators on a chart and found out off-the-shelf indicators beat the market?

Well, very recently I ran a comprehensive test on targets and stops on the ES using the default Stochastics settings. I took the basic Stochastics entry we talked about in those posts and then tested for the best target and the best stoploss.

My brand new computer is pretty fast and the test still took an hour (over 100,000 tests). I tested a wide range of possibilities.

Now if risk to reward is the Holy Grail, the test results should show a target that is many times larger than the stoploss, right?

That’s not what happened.

The top results all had a target that was much smaller than the stop. In fact, the best results had the stoploss being 5 times larger.

Completely opposite to what we’re told.

You know what else?

I scrolled all the way through the top 200 results. Do you know how many target/stop combinations in the top 200 had a “good” risk to reward ratio?

Zero.

Not one of the top 200 results had a target bigger than the stop.

So, if we only accept a reward bigger than our risk, we face the danger of turning a winning system into a losing system (or at least a barely profitable one).

The “bad” risk to reward beat the market. The “good” risk to reward didn’t come close.

The bottom line? A positive risk to reward is great if you can get it. Trend following uses this concept and I love trend following.

But a “good” risk to reward can be very hard to trade. And there are plenty of systems that work better with a reward far less than the risk.

We’ll talk more about that in tomorrow’s YouTube video.