I often talk to traders about trading boiling down to a numbers game. If you can get key metrics or pieces of data in your favour, then you are going to do well.
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.
It is the last two – your average profit and your average loss – that are the key data that traders should focus on. Keep losses small and profits larger.
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.
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.
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 the trading platforms available today, 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.
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.
The key message is that your winning percentage / strike rate is almost irrelevant when we incorporate a solid risk reward scenario in our trading.
The ASX 200 has suffered this week and dropped back below the key 5400 level and to its lowest level since mid July. Most of the top 20 stocks on the ASX dropped sharply this week dragging the index down.
There were 20 stocks in the top 500 that achieved new all time highs this week, with 7 at new all time lows. Would you like a list of these stocks? Let me know.
One of the current key levels is 5400 (shown below) and this is still likely to provide some support now that the index has fallen.
Image from MetaStock
After the Australian dollar broke higher from the ascending triangle a few weeks ago, it enjoyed some support from the key 0.7650 level and many were questioning why the AUD/USD was as high as it was, given the RBA’s outlook.
It has in the last couple of weeks however eased back through this key level but found some support around 0.7500. It will be interesting to see whether it can rally higher and retest the key level at 0.7650.
As I type this it is trading around 0.7560 just below the key level shown on the chart below.