2022-07-05 14:25:21
A mistake many traders make is to focus on their winning rate.
Why?
That’s because you can have a high winning rate and remain a losing trader.
Let me prove it to you…
Example 1
You have a 90% winning rate
Every time you’re right, you earn $1
Every time you’re wrong, you lose $20
And here’s the outcome of your next 10 trades…
Win Win Win Win Win Win Win Win Win Lose
Here’s what your profit and loss will look like:
+$1 +$1 +$1 +$1 +$1 +$1 +$1 +$1 +$1 - $20 = -$11
As you can see, a 90% winning rate will not make you a profitable trader if have a poor risk to reward ratio.
Now you might be thinking…
“So I’ll focus on favorable risk to reward ratio, like 1 to 10!”
Nope.
That’s because you can have a 1 to 5 risk to reward ratio but if your winning rate is too low, you’ll still lose.
Here’s how…
Example 2
You have a 10% winning rate
Every time you’re right, you earn $5
Every time you’re wrong, you lose $1
And here’s the outcome of your next 10 trades…
Lose Lose Lose Lose Lose Lose Lose Lose Lose Win
Here’s how your profit and loss will look like:
-$1 -$1 -$1 -$1 -$1 -$1 -$1- $1 -$1 +$5 = -$4
Clearly, a favorable risk to reward ratio isn’t enough either.
So, what’s the lesson?
Your winning rate and risk to reward ratio are useless on its own.
Instead, you must combine your winning rate and risk to reward ratio to know if you’ll make money in the long run.
So now the question is…
What’s the right balance of winning rate and risk to reward ratio?
Fortunately, there’s a simple formula for it…
Expectancy = (average gain x probability of gain) – (average loss x probability of loss)
Let me give you an example of how this works…
Example 3
Your winning rate is 40%
Your losing rate is 60%
The average size of your gain is $500
The average size of your loss is $300
So what is your expectancy?
Well, using the formula…
Expectancy = (average gain x probability of gain) – (average loss x probability of loss)
Expectancy = ($500 x 40%) – ($300 x 60%)
Expectancy = $20
Now how do you interpret this number? Simple, it means you can expect to make an average of $20 per trade.
So if he executes 100 trades, he can expect to make about $2,000 (calculation: $20 x 100 = $2,000)
As you can see, your expectancy (also known as an edge) is determined by both your winning rate and risk to reward ratio.
So the #1 rule of trading is this, you must have an edge in the markets.
Without it, nothing else matters.
It doesn’t matter if you have the best risk management because you’ll suffer death by a thousand cuts.
It doesn’t matter if you’re the most disciplined trader because you’ll end up as a disciplined loser.
It doesn’t matter if you have extensive trading knowledge because all trading strategies come down to this simple equation, whether you have an edge (or not).
Now you might be wondering…
“So how can I find an edge in the markets?”
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