We had a short conversation over at Twitter to discuss the importance of a higher probability setup (I assume this implies the setup provides higher winning rate) and risk/reward ratio. I quoted the twitter messages here. I thought this is an interesting discussion, and it shows the different risk perception, tolerance, and expectation of each trader.
There is no absolute right or wrong. That was just a casual discussion, and we were not trying to convince each other about anything.
Phileo99: speaking of risk/reward, isn’t it a bit overrated? I think the probability of the setup is more important than risk/reward ratio
you can have a 5:1 reward/risk ratio, but if the trade setup is poor quality and low probability, it is a bad trade to take.
instead of thinking risk/reward ratio, i prefer to think, “where can this instrument go?” “when are the odds in my favour?”
Trader Gav: @Phileo99 No.RR and probability should work together. Nobody is more important. low prob setups need higher RR to survive.
Phileo99 :@tradergav if consistency is the goal, then i’d have to disagree – probability of the setup is way more important than risk/reward
Phileo99 :i’d prefer to hit 10 singles vs. striking out 9times before i hit the homer …. easier on the psyche. losing streaks are hard to take.
Trader Gav: @Phileo99 it depends on your mentality. Profitable strategies can be 40% winning% with 1:3 RR consistently.
Phileo99: @tradergav true – there are different paths to +ve expectancy. we all choose our paths 🙂
Trader Gav:@Phileo99 Right. Common goal is +ve expectancy. Each has his/her own way.
Prospectus: @tradergav I’d rather have a higher probability setup so that the roll of the dice is less likely to bite me. But it’s my preference
Trader Gav:@Prospectus that’s normal. nothing wrong with that. Just personal preference. I weight more on RR and expectancy.
Phileo99: @tradergav I would agree that for system trading, neither is more important than the other. I was speaking from discretionary trading PoV
Prospectus :@tradergav I think that the right personality can clean up on big R:R–we see it all the time among the greats. That’s just not me.
I had some thoughts on this topic.
Firstly, regular readers might have known I favor the R/R concept. In other words, before establishing any trade, the risk/reward ratio is the first figure that being calculated on my screen. And, Yes, it determines if I am going to take the trade.
However, I do not expect every trader or any trader to have the same temperament or risk tolerance. One of my strategies is, in fact, running at around less than 50% winning rate but with high expectancy, in other words, each trade provides a high risk/reward ratio. Man, are you able to accept to be wrong 6 out of 10 times? Who doesn’t love to be always right? But I love $$ more.
Back then, out of curiosity, I took a trial of a signal service of two prominent analysts/traders (guess who? I’m not telling you). The selling point of their strategy was a high winning rate. If I still remember correctly, they claimed to have a 70% winning rate. However, after reviewing their trade history, I noticed, on average, they were making 30 pips by risking 70 or more on each trade.
Here is the calculation.
- Reward: 30 pips
- Risk: 70 pips
- winning rate:70%
- number of trade =100
Profit = (70% x 30 – 30% x 70) x 100 = 0
Well, so, with the impressive 70% winning rate, over a period of time, net profit is impressive 0. I did not consider break even trade, since It did not happen too much in the trade history. Winning % and Risk/Reward ratio is a pair of tools. They have to work together. Nobody loves losing streaks. However, you can win 70% of the time, with just a couple of losing trades to wipe out your previous earnings. So…you got the point.
There are two points that come out from here:
- You do not need to be right frequently in order to profit from this business. Winning % is not the only factor in profitability.
- Consistency, We are talking about trading profitable over a long haul. Trading is not an activity for one to feel good of being right all the time. It is for profit. If you are looking for the ‘Feeling good’ activity, then, look elsewhere. At the end of the day, you need the dollar to pay the bill.
Of course, I am not suggesting one to take sub-par set up with a big risk/reward ratio. That depends on your overall strategies, and that’s a different topic. The point is risk/reward ratio should part of your consideration when determining if you setup is a quality setup. A high-quality setup should not come with an inferior risk/reward ratio. Be it discretionary trading or system trading. The math remains the same. You got to know why you are taking the trade.
To play around with risk/reward calculation, have a look at my old post Accuracy vs Risk/Reward ratio.
OK, I talked too much.