An important reason why many people fail in the markets is that they do not employ sound money management methods. This is for a whole host of reasons and often because they get too emotionally involved.
When people are trading with their own money, it is close to impossible to not become emotionally involved at some stage. This is one reason why more and more traders are seeking to optimize their fx trading through automation platforms such as Tradeworks.
The bottom line is that money management will make or break you as a trader. This is a widely accepted fact. Proper money management rules have been proven over long periods of time and are not secrets to anyone.
To illustrate the importance of money management, consider this: even if someone had a method that guaranteed that 80 per cent of their trades were profitable, they could still lose money, due to poor money management. Similarly, another person’s trading method might have only a 30 per cent success rate, yet it would still be possible for this person to make money consistently. How can this be?
The key element is the size of the losses compared to the size of the profits. People who make a profit in 80 per cent of their trades may incur significant losses, far greater than all the profits they achieve. Similarly, people who realise a profit in only 30 per cent of their trades may achieve substantial profits and keep all of their losing trades relatively small in size. Within reasonable limits, it almost doesn’t matter how many of your trades are profitable when you employ sound money management principles.
This can be seen in the image below, which graphically depicts the change in account balance (starting with $20000) through ten trades – eight winning trades and only two losing trades. Despite the 80% strike rate, the example has still lost almost half of its starting capital due to the relative size of the profits and losses. This is key – it is not how often you get it right and wrong; it is what happens when you get it right and wrong.
Let’s explore this further. In this table below we have the hypothetical results of a series of 200 trades.
The first column shows different strike rates - a strike rate meaning the percentage of winning trades - from 10% to 100%. The next two columns show the number of winning and losing trades for each respective strike rate listed in the first column.
A simple way to measure the performance of your system is using 'R'. R represents 1 unit of your risk. For each trader, this will be different. It may be $100 or $1000 or anything. For each trade, you should be prepared to lose 1 unit of R. However, you should also try to structure your trades so you aim to achieve a profit of at least 1 unit of your R.
Dr. Van Tharp introduced this concept in his book titled 'Trade Your Way to Financial Freedom' when he talked about expectancy. Expectancy uses 4 important pieces of data - the percentage of winning trades, the percentage of losing trades, your average profit, and your average loss.
The 2nd last column is the most important in this entire table. It represents hypothetical 'Reward / Risk' situations.
A positive reward / risk ratio of 3:1 would mean we would be risking, for example, 50 pips to make 150 pips profit. This is a much more favourable situation than a negative reward / ratio of 1:2 where we could risk 50 pips to only make 25 pips. The whole purpose of this slide is to demonstrate that your winning percentage / strike rate is almost irrelevant when we incorporate a solid risk reward scenario in our trading.
If you consistently aim for a 1:2 reward / risk ratio and even with a good 60% strike rate, you are guaranteed to lose money. Why? Every time you have a loss, you are losing two times your average profit amount.
Imagine being able to use fx trade automation tools to achieve your desired outcome with exits?
Traders around the world are now increasingly using independent fx trade automation software to achieve exactly what they want within their risk management models.
Using the table above again, we can see that even if we have a very low strike rate, given a very favourable reward / risk ratio, we can still make money. In the first row, with a strike rate as low as 10% you can still make you money if you have a reward / risk ratio of 11:1. Both of these outcomes are rare (10% strike rate and 11:1 ratio) however it proves the mathematics behind a system's metrics.
In that specific example, there were 20 profitable trades and each trade netted 11 times R for a total of 220. Include 180 losses (each losing 1 R), you end up with a profit of 40R.
If you have a system that consistently aims for a reward / risk ratio of 2:1, you can have a strike rate as low as 34% and still make money (1/3 or 33.33% is the cut-off). Using independent fx trade automation software like Tradeworks, you can precisely setup your trading in this way. For example, you may always have your stop loss set at 25 pips and a profit target of 50 pips. In this case, you are aiming for a 2:1 ratio. Furthermore, traders are now creating this style of automated fx trading without any need for coding.
Reward / Risk ratio and its relationship to strike rate is more important than just strike rate alone. However, many traders focus so much on achieving the highest possible strike rate and in doing so ignore average loss and average profit and structuring their trades accordingly.
Posted by Stuart McPhee
Stuart McPhee is a private trader, best-selling author and personal trading coach and has consulted to numerous financial services companies in Australia and throughout South East Asia. Since 2001, Stuart has spoken live in front of tens of thousands of fellow traders from Mumbai to New York, Melbourne to Beijing, and many places in between. He has helped countless traders improve their performance with his expertise in technical analysis, trading psychology, risk management, the trading process and developing a trading plan. Stuart is also inhouse trading coach at Tradeworks where he assists our users in getting optimal value out of using our trade automation software.Facebook LinkedIn Twitter Google+