I have to admit that my beginnings in trading were quite erratic. At first, for the eyes of the novice everything seems quite easy, the thing should simply work if you buy LOW and sell HIGH, rinse and repeat.
However, what seems so obvious in theory is very difficult to achieve since the identification of the "low price" or the "high price" is a rather subjective thing for the uninformed.
Let's say that the behavior of a trader when he thinks he is buying low and selling high (LONGS) or vice versa (SHORTS) is very similar to flipping a coin and seeing if it comes up heads or tails. In a large enough succession of trades, it will thus tend toward a 50/50 chance of being right or wrong.
Therefore, the search for a strategy responds to the trader's concern to increase the chances of being right.
To do so, in Technical Analysis there are an infinite number of indicators and patterns, some more successful than others but all of them looking for a common objective, to increase the success rate or the probability of success (Win Rate).
However, increasing the Win rate is not as important as it may seem, in fact, a strategy with a Win rate of 50% or even lower could be totally profitable, and instead, a strategy with a Win rate of 75% could lead to ruin if you do not take care of other aspects much more important than this parameter, especially when you use leverage.
In fact, the variable that changes everything in this world of trading is the Risk-Reward Ratio.
Risk to reward ratio is the main risk management tool for limiting your risks. Calculating that and knowing your win rate, you can objectively decide whether a trade that you are planning to take is worth taking.
Thus, the Risk-Reward Ratio (RRR) of a trade is the quotient between the Projected Profit and the Risk of loss, or, in other words, the relationship between what I expect to win and what I am willing to lose in the trade.
When we are evaluating a specific trade, the Risk-Reward Ratio is calculated as follows:
R/R on LONGS= (Take Profit Price - Entry Price) / (Entry Price - Stop Loss Price)
R/R on SHORTS= (Entry Price - Take Profit Price) / (Stop Loss Price - Entry Price)
In the image below you will see 4 approaches to the same entry for a LONG trade:
In this sketch, you can see graphically the importance of the Risk-Reward Ratio applied in the chosen strategy:
With R/R ratio = 0.5, you need to win 2 trades in order to recover 1 losing trade, meaning that you need at least 70% win rate to cover losses of your trading.
With R/R ratio = 1, 1 winning trade, recover 1 losing trade and so, you need at least 50% win rate to cover your losses.
With R/R ratio = 2, 1 winning trade recovers 2 losing trades. You need at least 35% win rate to cover losses of your trading.
With R/R ratio = 3, 1 winning trade recovers 3 losing trades. You need at least 25% win rate to cover losses of your trading.
So, you can have a backtested strategy with a very high or very low Win rate, but that doesn't mean anything if your risk management is not balanced.
As you can understand, the psychology of the trader is really key when it comes to managing the trade, your aversion to risk can play tricks on you in your decisions and what at first may seem like a good strategy due to the projected win rate, can end up being a Pure disaster if the trader limits himself to closing operations as soon as they are in profit and assuming stop-loss losses. If you have many trades with very small profits, your Win Rate may be high, but it may also be enough to just a couple of stop-loss trades to ruin everything you have earned so far.
Or, on the contrary, you have a low win rate but the few times you get it right you win a lot, the question here is, are you prepared to assume consecutive Losses without affecting your trading?
To recap, the chosen strategy not only has to have a good WIN RATE, it also has to allow you a good Risk-Reward Ratio that is "bearable" with your psychology. Sometimes success is not hidden behind the theoretical numbers but in your ability not to lose money.
Throughout more than 7 years in this world of trading I have experimented with an infinite number of trading strategies, some more complicated and sophisticated and others more simple.
Over time I realized that a simple strategy using, for example, a single Moving-Average or another simple indicator (RSI) combined with the market trend gave me enough Win Rate (>60%) and Risk-Reward Ratio ( >1.2) theoretical to be a MODERATE winner, sufficient and bearable for my type of operation and psychological profile as a scalper.
Yes, keep it simple and work further on your risk management.
Your trading style, psychology and risk management will guide you over time toward the strategy that best suits you.
I hope you enjoyed this post and found it entertaining.
Let me know in the comments if you have any questions about what I have exposed or if you need me to develop something in more depth.
This post is the second in "My Trading Guide" saga, if you liked this one take a look at the previous ones as they will guide you in the topics that, perhaps, interest you the most.
Enjoy!