Talking about $Risk/Reward and winning%, in Twitter style

Posted on July 18th, 2009 in Trading Lessons

We had a short conversation over at Twitter to discuss the importance of 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 R/R concept. In other words, before establishing any trade, 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 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 high winning rate. If I still remember correctly, they claimed to have 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 are a pair of tool. They have to work together. Nobody loves losing streaks. However, you can win 70% of 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 of 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 else where. 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 setup with 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 determine if you setup is a quality setup. High quality setup should not come with 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.

From the desk of Tradergav.com

Tags: Money Management, Trading Lessons

Speculator Ed

Gav, your post was fine, because you've mentioned win percentage and also probability of setups. I can't help but get fired up on this topic because the general public, and even professionals that swears by risk reward ratio, usually do not mention probability of setups. I have fallen to this trap before thinking it was that simple, a ratio. This utter garbage scam was probably promoted by brokers, so that traders will go *try out* a new baseless strategy.

Speculator Ed

Correct Gav, your examples tie RR to probability of setup. It is comments like Brendan's, and also many pros that mention risk reward ratio, but do not mention probability of setups that misleads a lot of aspiring traders to think risk reward ratio is the key. The fact is it does not matter, it is the edge that matters.

Gav

btw, just read your post. You sound pissed! LOL... take it easy man.

Gav

I think, probably, it might be the loose definition of "Probability" in my post that caused the problem.

It's all good. Just a general discussion. Nothing is absolute right or wrong in this business.

Speculator Ed

Having a low risk/reward ratio may not result in good *total* profits. This may result in lower success rate and also potentially losses.

Math says risk/reward ratio does nothing. It is the probability of the setups that matter.

Gav

Interesting. Yeah, there might be a big flaw in my calculation above. I am not a PHD in Math ..LOL
Since you mentioned Math says risk/reward does nothing, it is the probability of the setup that matter, how do you come to this conclusion? Would you share the calculation to prove, it , in fact, does nothing to overall result, and even lower the success rate?I am interested in reading how does math prove the statement "risk/reward ratio does nothing"

Gav

So, we are back to square one. Risk/reward ratio has to work along with probability of setup. So, no argument here.

That's it. Let's discuss more when you become profitable later. Good luck.

Speculator Ed

I have created a post on my blog regarding this matter. Risk/Reward ratio alone does nothing, it is when tied to probability of the setup that matters.
http://edsfreedom.blogspot.com/2009/07/risk-rew...

Brendan

Having a high risk/reward ratio may not result in good profits. This may result in lower success rate and also potentially losses.

Speculator Ed

I think when professionals talk about risk reward ratio, they are really talking about the probability of what they think the stop needs to be in order to be proven wrong, versus what they think is probable for the target. But yea, risk reward ratio does nothing like your 0 profit example. It is the probability of the setup, and the amount needed to be proven wrong that matters. It gets complicated.

Gav

@Speculator Ed: The example is not meant to be a exact calculation of probability or risk/reward ratio. It meant to show, with inferior risk/reward ratio (e.g 70/30), over the long haul, even with success rate of 70%, if you are unlucky enough to have met the 30% of losing trades, you will might end up not earning anything at all, since you were earning small profits that are now,not enough to cover your loses.

Darn, I think I need to seriously improve my language and writing skill. Just can't explain my thought clearly.

Tom

I think both RR and setups are important in any trade but in some markets one or the other takes a bit more priority.

In Forex, the setups are pretty common but RR can kill you if your not on the right side of the trade (a la your Risk 70 pips to make 30 pips).

In stock trading you can risk 10 cents and make $1 more easily but the setups are tougher.

Different markets, different strokes IMHO, but both VERY important and necessary.