When it comes to trading or investing, success is determined by the approach you have taken. The majority of people are not aware of this approach.
Most traders believe success is determined by trading strategy. However, you can trade any strategy with different approaches.
Even while evaluating backtesting strategies, there are so many statistical parameters to analyse. However, there are two basic parameters that can be used to determine your approach to trading strategies.
Let me explain from the beginning.
Analyzing your trades involves two important factors:
- Success ratio
- Risk-reward ratio
The success ratio refers to the number of trades that went in your favor. For example, you took 10 trades during a period and 5 were profitable. Your success ratio is 50 % in that case.
This is relatively simple to understand.
It is generally believed that you can make money in trading if your success ratio is high. Therefore, the most common question regarding trading strategies is - what is the success rate?
But the success ratio alone is not sufficient. Making money does not require a higher success ratio.
When a trade was profitable, how much profit you made and when it turned against you or when it was a losing trade, how much loss you booked. Profitability depends on this equation.
This equation is known as the risk reward ratio or the payoff ratio of the profit factor or by other names. There are different names and versions of it.
Let's call it the risk-reward ratio. It calculates the ratio of loss to profit in the trades you took or the trade you are backtesting.
For example, 5 out of 10 trades you made were profitable. You made 30 points in 5 trades that were profitable. You lost 10 points in 5 trades that were losing trades.
Your average profit is 6 points (30 / 5).
Your average loss is 2 points (10 / 5).
Therefore, your risk-reward ratio is 2 : 6 or 1: 3. Let’s say 3. It shows that you made 3 points for every 1 point you lost.
We use this formula in Definedge platforms for backtesting and trading journals and call it the risk-reward ratio.
So, if your risk reward ratio is 2. It shows that you booked double returns in profitable trades than the average loss you booked in losing trades.
Higher success ratio or higher risk-reward ratio?
Most traders, especially newcomers are unaware of these things. Most experienced traders are also unaware that they have to determine the approach to their trading strategy. They must choose between a higher risk-reward ratio or a better success ratio.
Any trading strategy can have either approach.
Let's call them Hit Man or Marathon approaches (My terms).
After determining your method of entry, your method of exit depends on the approach you have taken.
The Hit Man Approach
Using an aggressive profit booking approach and exiting the trade early in profit will improve your success ratio. Your focus is on hit ratio, so I call it the hit man approach.
With this approach, your strategy will have a better hit ratio. However, your risk-reward ratio may not remain positive. There is a possibility that you will lose more when the trade goes against you, and that you will earn less when the trade goes in your favor. It is possible for this strategy to be profitable, but the total returns may not be substantial.
The approach is suitable for aggressive and very active traders who trade frequently. Their overall returns become substantial due to the significant number of trades they take. Profitability in this approach depends on a high success rate.
The Marathon approach
The second approach is to improve the risk-reward ratio of trades. I call it the marathon approach.
In order to achieve this, you must ensure that the average loss you book is less than the average profit you book. In order to achieve this goal, you will need to determine the maximum risk you are willing to accept in a trade. In order to limit your downside, you will need to cut losing trades on time. You will have to stay longer in profitable trades and improve your average profit numbers.
If you use this approach, your success ratio may be low, but your risk-reward ratio will be high, making you money. There is a possibility that you will generate some good returns with this approach, as the returns are substantial.
However, this approach is difficult to implement and needs practice. Cutting losses on time requires experience and discipline. Taking advantage of a trend and sitting in profitable trades is easier said than done.
If you study the portfolios of well-known investors or the approach of successful traders, you will realise that their success ratio is very low. In some cases it is 20% - 25%. But they have made remarkable returns over a period of time. It is because their average profit is way higher than their losses.
As a matter of fact, professional traders add more to their winning trades. This method is referred to as pyramiding. Adding more quantity to winning trades is not an easy task. We will discuss this more in depth later, but know that it is an extended version of the marathon approach.
It is unfortunate that some traders are unaware of this and keep changing their exit method based on recent trading experiences. The majority of people don't even have a good exit plan. This is primarily due to the fact that everyone is seeking the perfect exit strategy. Accept that it doesn’t exist.
Every approach has its advantages and disadvantages. Identify your style and preferences and determine your approach. Clarity and conviction will result from this process.
This concept applies to all types of traders and investors. Whether you are an active trader or someone who trades or invests occasionally.
The focus of traders is typically on returns and profit and loss. Returns over a period, returns every week and every day – even less than that.
In general, it is believed that if the session was profitable, all that you did during that session was good. A profitable session is good, but if you do not know what exactly went right, the profit may simply be the result of luck, and it cannot be sustained.
In this business, the outcome determines whether you made the right decision. If you made a profit, you did the right thing. No, please. Educate yourself. If you do the right thing, you can lose in some sessions. It is, however, because you wish to remain profitable over the long term, and as a result, your chances of success increase.
I have experienced profitable sessions with a 20% hit rate. However, it is difficult to keep booking losses and watching long losing streaks. Eventually, you gain conviction over a period of time.
In the long run, you will achieve better returns if you treat daily profit and loss or each trade profit and loss as just a number. Easier said than done - this needs practice and experience. However, it is more than that; it is the conviction that it is not necessary to make money in every trade or every day in order to remain profitable over time. Even when you are trading short-term or very short-term, your approach should be long-term.
The beginner finds it difficult to remain in profitable trades while riding the trend. They might have knowledge of riding the trend learned on the historical charts - most of it is hindsight analysis.
Operating at a lower success rate will be morally challenging for them.
It would be more comfortable for them to begin by booking profits after the trade becomes profitable by a certain percentage. Maintain a risk-reward ratio of at least 1.5. As your confidence grows, you can start riding trades.
You can also work on position size. Partitioning your entry and exit can assist you in managing your emotions to some extent. I’ll write more about that later.
Rather than focusing solely on your P&L, you should now consider your success rate and risk-reward ratio.
Success ratio and risk-reward ratio are significant for analysing trading systems.
For this purpose, the formula of Expectancy is very useful. It explains the relationship between the success rate and the risk – reward rate.
There are different versions of the expectancy formula as well.
I follow the Van Tharpe formula of Expectancy. It is used on all Definedge platforms.
The formula of expectancy is:
((Success ratio x Risk-reward Ratio) – Failure Ratio) / 100
If your success rate is 60% and your risk reward is 1:2.
Expectancy would be:
((60 x 2) – 40) / 100 =0.80
In simple terms, you made 120 points in 60 trades and lost 40 points in 40 trades. Average profit deducted from average loss (120 minus 40) is 80 points. Expectancy is 0.80.
Your expectancy should be positive when backtesting the strategy. Then you can look at other ratios.
@Prashant Shah This is a very important video. People generally like videos about new strategies or any indicators. But what you discussed in the video is about most important aspect which is spoken less about. If you would have noticed, you were explaining the concepts with a lot of passion. You have put in a lot of heart in explaining this as you wanted everyone to follow this thing for sure. I can relate to what you explained. Thank you having a video on trading psychology.