I have had quite a few emails over the past few days from struggling traders and the answer always comes down to a few basic principles which I will cover in this article.
Many traders think that if only they had a better strategy or could lay their hands on some secret Holy Grail, it would increase their win rate and fix everything.
Others just cannot correct common faults, such as chasing trades, cutting and reversing, closing too early, an inability to pull the trigger, or conversely – overtrading.
Yet I believe all these mistakes stem from bad Risk Management and the inability to balance Risk/Reward, Win Rate and Trading Edge.
You see, when one of these 3 parameters becomes unrealistic, it knocks everything else out of kilter. And if you don’t know whether the above 3 parameters work in practice, then how can you have any confidence in your trading? So is it surprising that this leads to the mistakes mentioned above?
Most successful traders I know have a win rate of 50% or less. Does this surprise you? What if I told you that expecting a high win rate puts undue pressure on yourself to win?
When your trading relies on having a very high win rate, suddenly losses take on a huge significance. Instead of treating losses as a cost of doing business, it becomes personal and that’s where the bad habits creep in. You stubbornly move your stoploss to avoid getting taken out the market, or double up on your next trade to make the money back. Then you take a huge loss and are in revenge mode or worse still, you’re scared to pull the trigger – you know how the story goes!
If your win rate does not need to be high because you aim for adequate reward to risk, then that particular pressure disappears.
Your win rate is low, but you remember somewhere that some trading guru said you should aim for really big risk/reward. So you place your trade and go for 20 times your risk (R). This is going to be the trade of the century… you can’t fail… after all, this going to pay for 20 losses, right?
After a few weeks of not hitting 20R, you wonder what went wrong.
You failed to take into account the timeframe you were trading on. Sure, you might be able to hit 20R on a swing trade, but it’s a tad unrealistic if you are trading intra-day. If the average daily range is 100 pips, you ain’t going to hit a 300 pip home run.
Also, blindly aiming for a fixed reward with no regard to market conditions is asking for all sorts of trouble, especially when you were 50 pips in profit and then price reverses at resistance, not only to your entry point, but into negative drawdown too – all because you were too stubborn to look at the reality of what the market was doing.
In short, you need to pick a target that is realistic in terms of market conditions, average range, hurdles that may hinder the path of price, opposing signals, news events, etc.
The lower the timeframe that you trade, the harder it will be to earn a decent risk/reward and the more pressure there will be to obtain a high win rate.
This is especially true of scalping where broker commissions will eat into a big chunk of your profit. This is not to say it isn’t possible, but it’s very stressful and will eventually burn you out.
The other reason is the market cycles through price swings more quickly on a lower timeframe and this gives less chance to run trades for decent profit.
This should not be confused with entering higher timeframe setups on a lower timeframe chart, where you are trying to reduce risk, but aiming for a higher timeframe reward.
The higher the timeframe you trade, the less setups there will be and the longer it will take for trades to play out. You will tie up your money in the market for longer, so you will have to be ok with waiting, especially after a loss or string of losses.
Conversely, trading a lower timeframe gives plenty opportunities to take trades and after a loss, a win is just around the corner. However you also run the risk of over-trading.
Finally, let’s get on to trading edge…
The main point behind this article was to re-affirm that strategy is not the only part of the trading equation that matters. It goes without saying that in order for good risk/reward and win ratio to succeed you need a strategy with an edge.
The strategy should by its very design embrace the above points, it should work with small stops and ensure good profit potential. It should allow you to time the market precisely, catch the trade as it turns or as it gathers momentum, without entering too late.
Timing is such an important aspect of trading, yet often overlooked. Bad timing produces bad risk/reward and it’s a downhill slope from there.
So to summarise…
Know what your timeframe, chosen instruments and trading edge are capable of. Find out what your “sweet spot” is in terms of risk/reward and win rate.
Once you have established this, you will be in a much better place psychologically to profit from the markets.
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