Thursday, July 23, 2009

07/23 Video on win-ratio and risk to reward

Just watched this video regarding having a high win-ratio vs. having a better risk:reward trade and think this is a Key concept in trading.

In a nutshell, the math is very simple. If you put together a very simple spreadsheet, you'll see that if you take small wins, and accept a much larger loss, you'll need to win a much higher percentage of times in order to make money at the end of the day, the week, the month.

On the other hand, if your wins are bigger than your losses, you don't need to be right a lot of times in order to make money at the end of the day, the week, the month.

It is part of the human phsychology to avoid losses. So, it is normal that a person will gravitate towards taking smaller profits, so they lose less often. However, look at the spreadsheet bellow (click to zoom), you'll see that the right thing to do is not to feel confortable with your wins, but set yourself up with a decent risk-to-reward ratio, so that your losses are not going to hurt you as much. Just to be clear, you will still HATE your losses no matter how small they are, but in the end of the day, you'll be making money.

I've been trading with a 1:1 win:loss ratio, that means if I take a bad trade, all I need is a good trade to recover. It is a lot easier to control capital allocation and risk:reward ratio than it is to trade with a set-up that has over 90% of win-ratio. If you have both, then FANTASTIC, you have a great risk:reward and a great win-ratio, you don't need anything else in life, just to keep doing what you're doing. :)

For my own trading, I've seen my win-ratio around the 68% mark for the good weeks and bellow 50% on the rough weeks. However, I am working consistently in keeping the risk:reward to at least 1:1. In many occasions I'm able to manage the stops on losing trades, reducing their costs and making the risk:reward even better than 1:1. In the long run, I like my odds of making money consistently starting with a decent risk:reward, then moving on to improving the win-ratio.

Like Richard Regan suggests on his video, it is much harder to achieve and sustain a very high win-ratio.

I hope this helps.


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