Following on from my previous newsletter, this week I will continue my exploration of the differences between trading perceptions and realities. There are various market myths floating around at anytime but among the most common I encounter from novice traders is on the subject of win to loss ratios. Pretty much everytime I teach a class or do a presentation, I am asked, “What is your percentage of winning to losing trades?” I do not baulk when asked this, as I clearly remember asking the very same question of an instructor when I first embarked upon my education in the markets. It is the thought on every new trader’s mind and due to the various forms of poor education that are available, emotions like greed and fear, and simply a lack of real trading experience, who can blame one for seeking an answer to this question? It is a natural concern for anyone who wishes to be profitable in their trading; however, as I soon learned, this common perception is very different from reality.
Although it may seem ideal to be able to go to the Forex markets on a weekly basis and turn over a high percentage of winning trades, this does not automatically qualify a trader’s overall consistency. Sure, it would be great if I could tell you right now that in the last month I took 10 trades and 7 of them were winners. You would think to yourself that I must be a pretty good trader and raking in the dollars easily with a run of success like that giving me 70% wins. Yet we often overlook the fact that consistent wins do not guarantee overall profits. It is not about how many trades you win, but instead it is really how you win and how you lose. For example, let’s say that with the example above of 7 wins and 3 losses, the actual profit and loss looked a little like this:
The statistics of a 70% hit rate sound very impressive when first heard, but in reality this stacks up very differently when the actual monetary profit and losses are highlighted above. In this example, the overall profit achieved was a total of $1,130 after having 7 winning trades, yet the daunting reality is that the 3 losses resulted in $1,350 of draw down. Therefore, while I may have enjoyed a high percentage of winning trades, I actually ended up being down by $220.00. Another alarming point of this example is that the largest winning trade was doubled in size by the largest losing trade. Suddenly I don’t feel like such a winner…Yes, it may still only be $220.00 but think about it: This is assuming that I can even get a 70% rate consistently, but in the real world of trading, this is very hard to do time and time again. If one day these figures slip to a 50% success rate, it does not take a genius to realize that I would end up with a far worse scenario than being $220.00 down. This would in fact be a much higher figure and we could start getting ourselves prepared for an account wipe-out in the not too distant future. In this example, the average winning trade was $161.00, but the average losing trade was a massive $450.00. With results like this, there is little chance for a lasting success in trading.
Now on the flipside of this, let us take a look at another set of trading results actually taken from a trading session carried out during a Forex Trader course I was teaching a few months ago. Here we can see a performance report of a number of trades carried out and the stats created from the trading platform:
Looking at these results, we can see that there was a total net profit of $1,288.60 made on this series of trades which at first glance suggests that the actual trading day was highly successful; however, as we delve deeper into the figures, the actual stats present a different story. Notice how the total number of trades was 27 (using multiple lots) and we in fact had 12 winners and 15 losers in the run? This equates to a final hit rate of just under 45%, yet we still made good money. A further investigation into the performance shows us that the simple reason for coming out on top was due to the fact that the average losing trade was $58.20, while the average winning trade came in at $180.13, giving an overall 1:3 risk to reward ratio. In the ongoing Extended Learning Track (XLT) – Forex program, I help my students over and over again to make this a vital part of their trading activities. Solid and logical trade management is one of the key aspects of consistently profitable Forex trading. Losing small is vital but any professional market speculator knows that they also need to squeeze out as much profit as they can during those winning trades, too. This creates a solid buffer to secure longevity of their trading and allows them to be wrong more often than right. When we look at this simple and undeniable fact in term of perception and reality, it quickly becomes obvious that the original idea that professional traders have to have to maintain high success rates is completely the opposite in reality. When you think about it, true profitable consistency can actually be derived from being wrong a majority of the time! All that is required is to maintain a healthy risk-to-reward ratio and to be disciplined enough to control losses and allow the winning trades the time to work.
There is no escaping the math behind the market and if you are reading this and saying to yourself, “Yes, but I would never let that happen to me,” then please, think again. Results like these are very common in ongoing activities of green traders and this is usually the result of a lack of solid education, poor trade planning and especially emotions like fear and greed. The fear of not making money on a trade causes many novices to take their profits too quickly and never allowing them to run. As long as they make some money, they are happy but what they don’t plan for is the day when they find themselves losing in the market. Because they are not generating large profits from the winners, it can often be the case that they take a couple of losing trades and quickly find themselves back at the breakeven point, then they end up chasing the market to be profitable and start to make irrational and unplanned decisions, jumping in and out of positions trying to quickly make back what they lost. It always amazes me how uneducated traders are so quick to close out a winning trade but not so keen to close out a loser. Shouldn’t the time to be bold and patient on a trade come when it is going in our favor? This makes far more sense to me as opposed to being eager to stay with a loser, hoping it will turn around. I would much rather be holding onto a winning position to get the best out of it instead of wrestling with a loser in the hope of making it back to breakeven.
There are many misconceptions and riddles dotted around the trading world and it is often the case that most novice traders are completely unaware of the things they need to know about before putting their hard-earned cash at risk. In these last two articles I hope that I have helped to shed some light on the necessary distinctions between what we think to be true and what is actually true. Next week, I bring you the final part of the series: Perception vs Reality, Part 3: Technical Analysis and Price Action.
Take care and be well,
Sam Evans firstname.lastname@example.org