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December 23, 2017, 05:23:41 AM |
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Whether you intend to trade crypto, stocks, forex, or pretty much anything else, lots of trading concepts are useful for you across all assets. The characteristics of a robust and reliable trading strategy is one such thing that is important to learn no matter what market you are operating in, whether you are a discretionary or systematic, fundamental or technical trader.
In trading, there is a well-known relationship between the win-rate of a trading strategy and the reward:risk ratio. Generally, the higher the win-rate, the lower the reward:risk ratio, and vice versa. This is important to understand in order to avoid being fooled by people who present you with their “amazing” trading strategies.
Oftentimes, these people will claim that their strategy have extremely high win-rates of 80-90%, but is that really what you should be looking for?
I saw someone recently used the analogy of a Volvo vs. a Tesla to make this point. Basically, it went like this: Tesla is a great car and feels wonderful to drive, plus it takes you to where you need to go in the shortest amount of time possible.
But when something goes wrong and one of the parts fail, you’re screwed. The Tesla isn’t moving anymore, and you don’t even know which part failed, much less how to fix it.
With the Volvo, however, you may not reach your destination that fast, but you know that you will eventually make it there, each and every time. When the car stops, you know that some googling and improvising is all you need to get it going again. Let’s say for example that your radiator is leaking. All you need is some tape to seal it temporarily until you can make your way to a shop.
With the Tesla, it’s not so easy.
Now imagine the Tesla is a high win-rate strategy and the Volvo is a high reward:risk ratio strategy. With the high win-rate strategy, things go really well until it stops working. When something goes wrong, you risk having to pay back all your wins for one stupid mistake. You have zero tolerance for error.
On the other hand, the high reward:risk strategy will still make you money regardless of your occasional mistakes and lack of discipline. For example, a win-rate of 40% and a 3:1 reward:risk ratio gives you room to lower your win-rate by another 10% and still make a profit.
Now that you know that high win-rate strategies have zero tolerance for error, you probably also understand why most experienced traders prefers to use strategies with a higher reward:risk ratio instead. Simply put, it gives you some more slack. And we all know that human traders need that.
This is also the reason why high win-rate, low reward:risk strategies are often used by robots and high frequency trading. Machines don’t make mistakes the same way as humans do, and they are therefore much better suited to trade with high win-rate strategies.
So, when you are developing your trading strategy, or even just trying to optimize your current strategy, focus on improving the reward:risk ratio of the strategy. Don’t try to boost the win-rate at the expense of the reward:risk ratio. It may look cool for people who are trying to sell their strategy to others, but it’s not very useful for real-world trading.
With a high reward:risk strategy, you know there is room for mistakes and unexpected events, which by the way do happen from time to time no matter how good you are. Because of this, you will also develop much greater confidence in your strategy, which is helpful in stopping you from making one of the main beginner mistakes in trading: constant strategy hopping.
"Systems don’t need to be changed. The trick is for a trader to develop a system to which he is compatible."
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