Why Smart Forex Traders Focus On Risk To Reward Rather Than Win Rate To Achieve Jaw Dropping Profits Without The Stress Of Winning All The Time
When looking at a Forex strategy to follow, a lot of people focus on the win rate of the strategy. After all, a strategy that wins more often has to be the most profitable, right?
Well, not necessarily.
As a matter of fact, the win rate is less important than the risk to reward ratio.
The Risk Reward Ratio is used to compare the expected returns of a trade to the amount of risk you are willing to take in order to capture these returns. Basically, how much are you willing to risk compared to how much you desire to gain.
Let’s say you were trading a strategy that uses a 100 pip stop loss and a 10 pip take profit. You are probably going to have a high win rate. But every time there is a losing trade, and there will be losing trades, you wipe out 10 winning trades.
A few losers wipes out a lot of your profits, and can even make the strategy unprofitable even with a high win rate.
On the other hand, let’s say you are trading a strategy with a 100 pip stop loss and a 150 pip take profit. With this type of system you only need to win 50% of the time, or even less, and you would still be profitable over the long run.
This is a much better strategy to use.
So, it is much more important to trade a strategy with a favorable risk to reward ratio, than a high win rate strategy.
In my opinion, you should use a risk to reward ratio of 1:2 or higher if you want to be a long term successful trader.
For example, if you risk $100, you should be looking to take profits of $200 or higher amounts. This is arguably the most important concept to grasp if you want to be a consistent, long-term, profitable trader.
The Breakdown Of A Profitable Strategy That Wins Only 50% Of The Time
So, how is it possible to be profitable while only winning 50% of your trades (or less)?
It really is quite simple.
Whenever you place a trade, there are various possible outcomes:
- The trade is triggered and stop loss is hit
- The trade is triggered and take profit is hit
- The trade is triggered and the trade closes with loss
- The trade is triggered and the trade closes with profit
The trick is to use a strategy where over time the wins are more profitable than the losses. On average, if we win more on our winning trades than we lose on our losing trades, we can lose half the time and still be profitable overall.
There is one thing to keep in mind.
Trading in the real world under live market conditions is not as black and white as always setting your take profit larger than your stop loss size.
It can be more complex than that. But ON AVERAGE, your winning trades should be greater in value than your losing trades if you hope to be profitable.
IMPORTANT: When you learn to make money with a 50% win rate, you develop a healthy attitude to losing necessary for being a long term profitable trader.
You will be able to stay calm in the face of adversity and stick to the trading strategy where other traders would abandon trading prematurely and miss out on future profits. In short, making money with a low success rate is a trading skill without which you will not succeed.
I believe that learning to be profitable with a trading strategy with a low win rate is the most important trading skill a trader can develop. Therefore, I want to go over and exercise that you can do to understand just how powerful this concept really is.
The Coin Flipping Exercise
But there is a difference between understanding this concept and accepting this concept with such conviction that you can put it into practice and trade through all market conditions. When your account is in consolidation or drawdown, you WILL start to question whether this is really the key to success.
Doubts will creep in.
The only way to make this part of your belief system is to experience it for yourselves. Therefore, there is an exercise you can do to start gaining confidence in this concept. It is called “The Coin Flipping Exercise”.
The Coin Flipping Rules
Imagine you have $100 to trade with and you are trading $1 per trade. Find the biggest coin in your local currency.
You are going to flip the coin to represent a trade, Heads being a Winner, and Tails being a Loser.
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- For every winning flip (Heads), pay yourself $2.00
- For every losing flip (Tails), deduct $1.00
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Get out a piece of paper or use your computer to keep track of your balance.
Flip the coin 100 times, and recalculate your balance after each flip.
Pay attention to your emotional response to each flip. Yes, this is a silly exercise and there is no real money at risk. But the tendency is to be very interested in the outcome of the flips when you start.
- The first 10-20 flips are when you get excited about the wins (Heads) and suffer with the losses (Tails).
- After that, you start to realize the odds are stacked in your favor and the outcome becomes less emotional.
Don’t just think about this exercise. I want you to actually do it! Trading is a skill just like shooting a basketball or hitting a golf ball. I can tell you what to do and you can understand the concept.
But to truly gain experience, you must DO the activity.
This is a simple way for you to practice trading with a positive risk to reward ratio and experience how powerful this is for yourselves. After 100 flips, you’ll see that by trading this way you are profitable.
And that really is the point, right?
Do this exercise. And whenever you feel your confidence level waning during your trading, repeat the exercise.
Trading with a positive risk to reward, through the up, sideways and down times is the KEY to long term trading success. And this coin flipping exercise can help you start to realize the losses don’t really matter over the long run.
In my experience, most people cannot handle the pain of losing. When they see 1 or 2 losing trades with the strategy they are using, they are off looking for something “better”, or tweaking the system until they finally destroy it.
I do not want this to happen to you because it is my goal to help you do what most people cannot… trade the Forex market profitably over the long term.
Please do the coin flipping exercise now. Don’t just think about it. Do it.
Statistical Validity
One of the important things The Coin Flipping Exercise can teach you is there needs to be a certain amount of flips before the logic of the exercise becomes apparent. This is called statistical validity.
Definition: Statistical Validity is the extent to which the conclusions drawn from a statistical test are accurate and reliable. To achieve statistical validity, researchers must have an adequate sample size and pick the right statistical test to analyze the data.
For example, let’s say you only flip the coin 5 times, and 4 were losers. If you gave up at this point, you would be ending as a loser, without giving the logic of the risk to reward ratio a chance to show itself.
On the other hand, if you only flip the coin 5 times, and 4 were winners, you might create the wrong expectations. Thinking you are going to win all the time is just as dangerous as giving up too early because you set unachievable expectations for yourself that will not be met in the future.
However, if you flip a coin 100 times, you will go through winning streaks, losing streaks and time periods where it goes back and forth. But in the end, you should be profitable.
The same commitment must also be made when trading a Forex strategy through all market conditions. You need to give the strategy time to prove itself by trading a lot of trades. Only this way will you prove to yourself the overall risk to reward strategy leads to long term profits.
What Are R Multiples And Why We Use Them
As you can tell, I focus on risk to reward because it is the MAJOR reason for my success.
Risk:Reward Ratio is such an important part of profitable trading, I even use it to track performance. To track my performance I use something called R-Multiples.
I want to be clear, measuring trading performance by R-Multiples is not something I created.
The credit goes to Dr. Van Tharp, a world leader on position sizing and trading psychology.
“R” is simply a way of looking at the risk to reward ratio. When we place a trade, we also place a stop loss. Regardless of whether you look at this stop loss value in terms of money, percentage of your account or pips, this is the amount you are risking when you place the trade.
Therefore, the amount you are risking is the value of R, or 1R.
Essentially we are going to be tracking performance in terms of the amount risked versus the amount gained/lost.
The Golden Rule of trading is to make more money on winning trades than you lose on losing trades. These are words to live by as a trader.
In other words, keep losses at a level of 1R and make profits that are +1R or higher. (The higher the better). That is the KEY to long-term success.
In terms of R-Multiples, losing trades are -1R. A breakeven trade is 0R. And a winning trade is anything over 0R.
In order to give our strategy the best possible opportunity for long term success, we strive to have winning trades reaching +2R or greater.
Now to be clear… not every trade is going to hit its R-Multiple target. Due to trailing our stop loss and the way the market moves, we can have successful trades with any R-Multiple value from 0R up to the target R-Multiple we set at the beginning of the trade.
Why R-Multiples Are Perfect For Tracking Performance
In order to be profitable as a trader, any kind of trader, you need to make more money on winning trades than you lose on losing trades. Are you tired of hearing this yet?
To do this, you need to trade in a way where you have a positive risk to reward ratio.
In order to bring this point home, let’s look at an example.
Forex Trading Blast Off teaches a simple strategy to trade the GBPJPY currency pair. Yes, that is right, only ONE currency pair. However, just because you are only trading one currency pair, you are not limited to creating only one income stream.
My entire way of trading focuses on risk to reward ratios. I trade MULTIPLE accounts with the same strategy on the same currency pair.
The only thing that changes on each account is the R-Multiple Target:
- Account 1: 3R Target
- Account 3: 5R Target
- Account 4: 10R Target
Why would I do this? Why not just trade the “best” R-Multiple target?
Because you just don’t know beforehand what the market is going to give you. Therefore, it is best to have an account with a smaller R-Multiple target that hits targets on short moves AND accounts with larger R-Multiple targets that get more profits on larger moves.
This is why there are different results on each account I trade, even though I am trading the exact same currency pair and strategy on each.
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Clarification: I trade the same strategy with the exact risk percentage per trade with different profit targets on 3 separate accounts, creating multiple income streams.
Having different R-Multiple targets means different results over time. But I have found this is the best way to maximize my profits over the long run instead of just choosing 1 R-Multiple target.
It is important to keep in mind that I view EACH account as a separate and independent income stream. I am not concerned about taking the same trade on different accounts… because I compartmentalize my thinking and am only placing 1 trade per account.
As long as the account is profitable, that is a successful income stream. And since I am trading 3R, 5R and 10R targets on each account, I am fulfilling the essential goal of making more on winning trades than I lose on losing trades.
Trading this way, some accounts are going to be more profitable than others. But I am not leaving profits on the table by only trading one R-Multiple target. When the market gives BIG moves, as it will from time to time... I will be there to collect them.
In Conclusion
Traders are obsessed with winning trades. And I get it. Who doesn’t like to be a winner and get into a trade and out of it with profit?
But it is important to keep in mind that HOW MUCH you win on winning trades compared to how much you lose on losing trades is the real path to profitability.
Risk to reward COMBINED with win rate is the answer. You need to win ENOUGH high risk to reward trades in order to be profitable. And with high risk to reward trading, ENOUGH can be less than 50%.
Edward Lomax
