For any trader, regardless of the instrument or instruments traded, maximizing reward-to-risk ratio is the most crucial challenge. This is because the average reward-to-risk ratio of all executed trades over a given time period is equal to a trader's profitability over that time.
Normal human emotions push traders in the direction of aiming for a high win ratio and minimal draw downs in their equity curve. Yet while trading profitably in this style is possible, it is usually extremely difficult to achieve with sufficient consistency to meet financial goals. Traders can usually increase their reward-to-risk ratio, and hence their overall profitability, by worrying less about the percentage of winning trades and more about how big the winning trades are when they come. To achieve this, it is necessary to overcome any emotional and financial hurdles that prevent forgetting about the win ratio and equity draw downs. It is easy to give such general advice, but probably much more helpful to focus on the specific actions traders can take to achieve this instead.
Traders should firstly ensure they follow a sound money management strategy. Risking a low percentage of equity on each trade can help to reduce day to day emotional pressure, and allow the account to comfortably weather the inevitable losing streaks when they come. By risking a percentage of equity per trade, traders can ensure that they are betting smaller during losing streaks and bigger during winning streaks. This should make it emotionally easier to pursue higher reward / lower risk trading styles and strategies. Adjusting the position sizes based upon recent volatility, as well as by percentage of equity, can also help.
Secondly, traders can be more selective with their trade entries. Instead of looking for entries that are likely to produce a certain minimal amount of profit and hoping for a runner, entry criteria can be adjusted towards aiming to enter when large moves are more likely. In other words, look to enter when there is a 20% chance of achieving a reward of 10 X risk, rather than when there is a 55% change of achieving 1 X risk.
Thirdly, investigate the best-kept secret weapon for improving reward-to-risk ratios: tightening stop losses! Review past trades and note just how many of the very best trades took off straight away with hardly any draw down. Sometimes it is possible to make a strategy profitable just by halving the stop loss. Get out of the mentality that tells you that a stop loss is there to let your trade be a winner, remember instead that a stop loss is there to limit your losses.
Finally, exit strategies are crucial, and this is obvious. Partial exits at low reward-to-risk multiples should be ruled out. Despite the inevitable retests, it is a superior strategy to move stops to break even when the appropriate moment has been reached.
It is equally obvious that any exit strategy needs to allow for a big runner to be held to a high reward-to-risk multiple before exit. This can be achieved in several ways. Fundamental analysis can be used to determine the likely strength and duration of a continuing trend. The volatility of the instrument over recent months and years can also be used to indicate what sort of pip or point targets are feasible and have the most profitable profile.
Trailing stops, including Chandelier stops, can also be useful, especially in combination with time-based exits. Alternatively, trailing stops can be tightened based upon the reward-to-risk multiple already achieved. For example, let the stop give up 75% of the paper profit once 3:1 has been achieved, 50% at 6:1, 25% at 9:1, etc.
Volatility should be factored in to the reward-to-risk, as if the risk is unusually high, it might be better to be satisfied with a relatively conservative profit target for that trade.
To summarize: don't be afraid to be stopped out due to a tight stop (within reason), and don't be afraid to let a small winner turn into a loser. Don't be in a hurry to take profits either!
by Cina Coren
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