THE IDEAL POSITIVE EXPECTANCY
“It is
especially in short-term trading, with a wealth of trading signals, that
consistent trading in the overall trend direction pays off.” – Arne and Falk
Elsner
One of the big factors in trading success is to think in terms of the
risk-to-reward ratio (RRR). That’s your risk in terms of the potential reward.
You know, for you to survive in the markets, you’ve to target at least two
dollars for every dollar your risk.
Some target three, four, five, or more dollars for each dollar they risk;
which is fine. This is the logic behind positive expectancy. In contrast to
this, anyone who risks two, three, five… two hundred or five hundred dollars to
target one dollar or a few dollars is using a negative expectancy approach.
Anyone who doesn’t use stops and who’s determined to run the losses till they
break even is using a negative (worse) expectancy approach. The fact is: anyone
using a negative expectancy approach can’t last long in the markets.
The
benefits of the RRR of 1:2
Now, let’s go back to the idea of 1:2. In all the years of my grappling
with the markets, I’ve seen that the RRR of 1 to 2 is the most optimal one.
These are some of the reasons.
1. The 1:2
expectancy is the least that should be sought by sensible traders. Risking one
dollar to target less than two dollars is really not in the trader’s best
interest.
2. With optimal stops
and targets, the ratio 1:2 is easily achieved than 1:3, 1:4, 1:5… 1:10 etc.
While a higher RRR like 1:5 requires a hit rate of 20% or less to attain
profits, it’s very difficult to practice, requires a high level of discipline,
and requires an unending patience to run the winners. How many traders can surmount
the emotional hurdles?
3. With rational
and logical fine-tuning of one’s strategy, one might be able to achieve a hit
rate of 40% or more over time, thus the RRR of 1 to 2 is enough to make one a
consistent winner.
4. The best
trending pairs and crosses in Forex are often the ones most analysts tend to
ignore. Remember that you need price
movement before you can make money. No movement in the price, no profits/loss. If
you trade highly trending Forex instruments, it’s more probable that you would
achieve good results with the expectancy of 1:2 so that your stops/targets are
triggered quickly as you look at short-term and medium-term biases. When more
liquid and highly trending trading instruments are sought and played, the
possibility of roll-downs is reduced while the rise in equity becomes
noticeable. When the EURAUD is bullish, you need not give yourself any headache
by going for complicated analysis. When the cross is bullish, you’d see the
price going upwards.
5. If you use the
RRR of 1 to 2, it’ll be possible for you to reach breakeven with a hit rate of
33.3%. This means that recent losses are easily recovered. The risk-to-reward
of 1 to 2 is indeed a magic ratio!
Conclusion: It’s very
crucial that we acknowledge we can’t be correct most of the time, or often more
than half of all our orders. Our hit rate may be far lower than that, but we’ll
become profitable if we know how to handle our negative and positive trades,
things over which we’ve control (especially when it comes to their effect on
our portfolio over time). Using high lot sizes relative to our portfolio size
is like courting financial disaster. It’s thus far safer to stake a maximum of
1% per trade while targeting at least, 2 dollar for each dollar that is at
stake.
This piece is ended with the quote
below:
“It takes patience and a strong commitment to study the
markets and identify good setups... But in the end, it's worth it. If you
carefully select high probability setups, you'll trade more profitably and
you'll be more satisfied with your performance.” – Joe Ross
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