Lessons from the Pros

Forex

Is Risk/Reward Ratio or Win/Loss Ratio More Important?

What does it take to be a consistently profitable Forex Trader? I think I’ve lost count of how many times I’ve been asked this question. Everybody wants to know, and many think it all boils down to some convoluted perfect strategy. It simply comes down to knowing as much as you can about the environment you are working in and then, knowing as much as you can about how you work yourself.

Currency markets can either go up, down or sideways, giving us limited choice and only a few outcomes. Yet the average trader’s results fluctuate in such wild swings that we often forget and disregard the simplicity of how any financial market really functions. After all, if you have more willing buyers, this creates demand and when this is higher than the number of willing sellers, also known as supply, prices will go up. On the flipside, if the willing sellers outnumber the willing buyers and the supply is larger, the price will fall.

Using a simple rules-based approach like Online Trading Academy’s Core Strategy, you can learn to spot where the big banks and institutions are buying and selling, objectively highlighting the best areas to enter the markets when supply and demand are imbalanced. Regular readers of my articles will know that I’ve covered this in many of my previous posts. For this week’s topic though, I would like to look at two key dynamics which hugely impact our trading results and clearly define individual trading style.

Look at the diagram below:

See saw with win/loss ratio on one side and risk/reward ration on the other.

Here we have two trading measurements of win/loss ratio and risk to reward ratio. No matter your style of market speculation or what plan you’re using, these two dynamics will be the most important measurements of your overall results. See how I have placed them on a balance of sorts? Like a seesaw in a playground; when one side goes up, the other must come down.

In a perfect world, we would love to average 10 to 1 reward to risk ratios and be right 90% of the time, but let’s face it, that’s probably not going to happen. Yes, we can increase our win/loss ratio on a trade by trade basis, and we can also improve our risk to reward ratios, but as one of these measurements goes up the other will inevitably go down. Just like on the seesaw, you can tip one side up, but the other side will lose ground. So, the question to ask yourself now is, what measurement is more important to you?

I’ve met many traders who like to hit home runs of sorts. They have low win/loss ratios, sometimes between 20% and 30% or maybe less. However, when they do get a trade right it’s a big win, sometimes over 10 times their average small loss. These market speculators are not bothered about being right all the time. They know over time the strategy works and when they are right, they will be right in a big way, so they can afford to take a series of small losses and play the game over the long term.

On the flip side of that, there are FX traders out there who function better and more consistently when they get things right more frequently. These speculators might be looking for winners anywhere between 45% and 65% of the time. They thrive on their win/loss ratio and this gives them confidence in pulling the trigger. However, their average win to average loss ratio is generally much smaller, say around 3:1.

Free Trading WorkshopPersonally, I thought long and hard about how I function more effectively in the market, going for bigger wins less frequently or aiming for smaller average wins more often. If I’m being consistent, both styles work for me. I’m happy to mix it up and choose to shoot for smaller risk to reward ratios with a higher win rate when trading intraday and aim for the less frequent winners with much larger average wins on my longer-term trades.

As I said before, it’s really all about what makes you function and work consistently. Being able to stick to your plan and take your own emotions out of the process is key, no matter the individual strategy. The takeaway from this is to always make sure that your average win is at least three times the size of your average loss. Even if your win/loss ratio is falling a little on the low side, a good risk to reward ratio is an advantage that should help keep the seesaw balanced as you get better and more skilled in time.

I hope this was helpful and see you next time,

Sam Evans – sam.evans@tradingacademy.com


DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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