All of us trade to make money. You may be searching for the holy grail, a system which has a high win rate coupled with high rewards.
All of us might have been taught that we need a good risk to reward ratio, ie. 1:2 and higher. Take a deep breath before I burst your bubble.
You do not need a good risk to reward ratio to make money. Allow me to share a strategy and the components of trades that will grow your account size.
A real life story
There are 2 sides of every coin. This means that there is a 50% chance the coin will land on its head and the chance of it landing on its tail is also 50%.
As a game, if you get heads, you win $2. If you get tails, you lose $1. Since there is a 50% chance the coin will land on its head, your win rate is 50%. Your risk to reward ratio is 1:2.
After tossing a coin 100 times, your win rate could be less than 50%! It is possible that you get tails 70% of the time. It is also possible that you get tails for 70 consecutive tosses!
The moral of the story: you can have an excellent risk to reward ratio and still not make money in trading.
After reviewing my trades for the first half of the year, I realized that I took way too few trades due to my strict adherence of the 1:1 risk to reward ratio rule. This resulted in tiny profits and losses at times.
Change in perspective
Through the review, it dawned upon me that although I take trades which present a good risk to reward ratio, it is ultimately Mr Market who determines if I make money (after proper analysis, of course).
I cannot ask Mr Market to go my way. I cannot depend on the risk to reward ratio of my trades to work out favorably as well. What can I rely on? The answer is My risk.
From the conversations with profitable traders and personal experience, I have not come across anyone who claims to have both a high win rate and excellent risk to reward ratio. They are mutually exclusive.
This leads me to constantly ask myself which I would like to focus on or even find a balance. What do I need to understand about having a high win rate and improving my risk to reward ratio?
Understand and accept
Here’s one options strategy on oil futures I use.
Above is a chart of crude oil futures (/CL), I proceed to mark out the support and resistance zones.
/CL is sort of moving sideways. I decided to employ a credit spread strategy.
How does this work? Basically I collected some money by selling credit spreads. By being bullish here and selling credit spreads, as long as the price of oil stays above $50 at the time of expiry, I get to collect premiums (money from selling the option). However, when things go awry and the price of oil goes way below 50, I will cut my losses at 2 times the amount I collected.
My risk to reward here is 2:1. However, the probability of me collecting premiums is way higher at 90%. In options theory, a delta of 0.1 means that the chance for the price to hit a certain level is 10%. This means that there is a 90% chance oil will not reach the price levels that I have set. This is a rough gauge but at least something to refer to.
Using this strategy, I need to accept the trade-off between a high win rate and a favorable risk to reward ratio.
If options interests you, check out the 3MT program by Jay.
Understanding the strategy you choose and accepting its trade-off are essential. You must know yourself well and discover suitable strategies.
As we are at the tail end of 2019, why not take things slower to reflect and learn?
Swim Trading Resident Columnist