SCOTT WELSH TRADING BLOG

Can A Bad Risk-To-Reward Ratio Make Millions?

Can A Bad Risk-To-Reward Ratio Make Millions?

Feb. 13, 2019

I’ve talked about it many times.

But it’s still out there.

The ONLY way to make money trading is to have a positive risk-to-reward ratio.

What does that mean?

It means, of course, that our winning trades HAVE to be larger than our losing trades.

Because no trader can ever win more than 50% of his trades, the idea is that big winners make up for the fact that traders win so infrequently.

Sure, we can only win 40% of our trades, but if our winners are twice as big as our losers (positive risk-to-reward!), then we’ll make money in the end.

The math works out.

If we win 40% of the time and make $2,000 each time, at the end of ten trades we’ll make $8,000.

If we lose 60% of the time and lose $1,000 each time, at the end of ten trades we’ll lose $6,000.

At the end of every ten trades, we’ll be up $2,000. We win!

And that’s why a positive risk-to-reward is the only way to go.

Hmm.

Doesn’t the math also work the other way?

If we win 70% of our trades but only make half of what we risk, don’t we still win?

7 trades at $1,000 minus 3 trades at $2,000 = $1,000 ($7,000-$6,000).

That’s a win, right? It’s not quite as much as our first example, but it’s a business plan no casino would turn down.

But my second example is bogus because of the win percentage. Traders can’t win that often.

Or can they?

Using a real life example of a robot I currently trade, let’s dig into the results of a negative risk-to-reward system.

In this daytrading system (called the Hornet), the stoploss is 3.6 times bigger than the profit target.

Ouch. That’s never going to work.

Here’s the Performance Report for this system from 2003-2019 (on only the USDJPY):

What’s up with that? This system has a negative risk-to-reward, so my understanding was that it would never work.

Instead, a hypothetical $10,000 account grew to $3.8 million.

A few important things about this report.

One, notice the average win and average loss. Although the stoploss is 3.6 times larger, that is an “emergency” stop. Most trades don’t hit that full stop-out. In fact, this usually happens about 4-6 times a year at most.

The actual average loss is only about 2.1 times bigger than the average win. When you add in a 76% win rate, the math says we should have a profitable system.

Do we?

I’ve been trading this system since 2013 and the math seems to be holding up.

Not only that, when you add in a feature like auto-sizing to your trading (the trade size goes up automatically as your account goes up), it’s possible to see exponential growth.

[Do I wish I had employed auto-sizing on this pair and done nothing else since 2013? Yes, yes I do.]

Another important takeaway is this: if there’s a system out there you want to trade but have been scared off by people telling you bad risk-to-reward won’t work, start trading that system!

Negative risk-to-reward is perfectly okay as long as the math stays consistent.

As long as the average win and average loss stays steady and the win percentage doesn’t fall off a cliff, a system with bad risk-to-reward is nothing to be afraid of.

Now, does that mean positive risk-to-reward is a bad thing?

We’ll find out in our next email.

To get on the email list, go here.

To see my weekly YouTube video, go here.

 

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.