29 May In Praise of “Bad” Reward to Risk
In Praise of “Bad” Reward to Risk
May 29, 2023
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If had was forced to pick one style of trading that’s better and more robust than any other method, I would pick trend following.
Trend following has worked for centuries and will work far into the future.
But there’s a cost for that robustness.
Trend following loses. Good trend following fails more than it wins. It has long drawdown periods. It suffers mightily when trends are on vacation.
And most people can’t take losing. Not even a little bit.
Trend following, while superior mathematically, is inferior emotionally.
And guess what?
Trading is 98% emotional.
That’s a big problem.
So, if I had to pick one way of trading that can grow an account in a short period of time, I’d choose something different.
If I had to recommend one way of trading to an absolute beginner, I wouldn’t pick trend following. I’d choose something different.
The problem is that my “something different” is soundly criticized by the titans of trading and the index fund industrial complex.
What I would pick is “bad” reward to risk trading.
What does “bad” mean? It means that your profit is much smaller than your loss. We’re told, unequivocally and angrily, that we have to have a “good” reward to risk.
For every loss, our profit has to be 2x-5x larger.
That’s how the professionals do it. That’s the best way to do it.
But is it, though?
A decade ago, I started testing everything. I started with what I was supposed to do: good reward to risk.
And you know what? It stunk.
It stunk out loud.
The drawdowns were massive and the win percentages were miniscule. In fact, the best backtest I saw early on was a magnificent Equity Curve of a system with over a 10:1 reward to risk. For every $10 lost, over $100 was gained.
And the win percentage was 11%.
Who in their right minds could trade a 11% system for the next decade?
How’s your system doing trading our life savings, honey?
Another down month, dear. But we should get a winner maybe 6-10 weeks from now.
Then I started testing systems with high win percentages. Of course, these had negative reward to risk ratios.
For every $10 gained, I would lose $30. Or $50. Or more!
Clearly, those were doomed. Surely, I was moronically barking up the wrong tree.
But that’s not what the math said.
The math said that high win-percentage systems stack profits on top of profits. They store a bunch of winners in the account that pay off the occasional loser. And those tested accounts were constantly growing.
How’s your system doing, honey?
Another good month, dear. We’ll probably get a loser sometime soon, but we’re up from last month.
And think about that beginner trader.
More than anything, what do new traders need?
Right when they turn on the robot or press the button on their first trade, what needs to happen very soon?
And what’s going to give that to them? An 11% system or a 74% system?
What are the chances this bad reward to risk Equity Curve is going to produce profit at any given time for the trader who starts trading it?
No matter when a trader starts, a bad reward to risk system’s high win rate will most likely produce something positive.
My love for the eternal nature of trend following has made me forget this incredibly important fact. And that’s a mistake.
Bad reward to risk systems are absolutely worth looking into.
And we’ll look at such a system in our next Newsletter.
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.