The great two-to-one scam

September has traditionally been a tough month for markets, but this year it’s really taken no prisoners.

And we can’t pretend that this is just an end-of-the-summer blip. Over the past quarter, the FTSE has lost 14% of its value – more than at any time since the dot-com bubble burst.

There are plenty of people panicking out there – about the state of their investments … their lack of pension … or simply how they’re going to put food on the table next week.

Of course, panicking never helps anyone.

Nor does waiting for politicians to come to our aid. (By the way, thanks for that council tax freeze Mr Osborne – should save me all of £2 a week.)

Which is why I hope that you caught my email on Wednesday – this has already generated a lot of talk among traders – and a lot of questions.

One of those I’d like to address here – and it gets right to the heart of one of my old trading bug-bears.

It’s the great 2-to-1 con.

I’m talking about risk reward ratios. And the notion that some are inherently better than others.

For me, it’s one of the key misunderstandings and prejudices I see again and again – even among experienced traders, and so-called “experts”.

Missing the point

The cry I hear repeated so often is that we should all be trading with a ratio of 2:1.

I.e. For every £1 you’re risking, you’ve a potential reward of £2.

That way, the “trading expert” will cheerfully tell you: If you get it wrong half the time – you’ll still make money!

That would be all well and good if we were guessing heads or tails on the toss of a coin.

But we’re not – we’re trading.

And we’re risking our money on these trades – so we need a complete picture before we have our heads turned by some filly with favourable odds who doesn’t stand a hope in hell of making it to finish line.

Chasing high returns

A 4:1 reward ratio may sound like an extreme example to make a point – but there are traders out there who consistently try to trade like this.

Sounds nice – £400 return for every £100 you risk.

But ask these same traders how often they win.

And just how many £100s go into their spread-bet firm’s coffers before they see their £400s.

Chances are, if they are successful traders, that they’ll only be winning around 25% of their trades.

Overall, they’re still profitable – which is great. But suddenly the 4:1 ratio looks less exciting than it did before.

The edge is all that matters

Risk reward ratios are no judge of the profitability of a system.

To really see whether a system has an “edge” – you need to know the success rate.

If you have a high reward ratio (such as 4:1) – you won’t need to win many trades.

If, on the other hand, you have a low or negative reward ratio (such as 1:2) – you’ll need to win more often.

But that’s not the end of the story.

A lower reward ratio will inevitably have a better chance of winning – what matters is matching up the two statistics in a way that suits you: reward ratio AND success rate.

Tank or Ferarri?

Stating that 4:1 reward ratios are better than 1:1 or 1:2 ratios, is a bit like saying that an army tank is better than a Ferarri simply because it’s bigger.

What matters is which one is going to get you to your profit goal faster and by a route that suits you.

Winning a trade on a 4:1 reward ratio is not easy – there simply aren’t as many profit opportunities like that out there. So, if you can muster a 25% success rate on this kind of trade – you’re doing well.

On the other hand, trades with a 1:2 reward ratio (risking £2 to make £1) will require you to be right more often, but it’s a heck of a lot easier to be right about these relatively smaller rewards.

Neither type of trade is “better” than the other – they are different trading styles, and each has its merits.

A 4:1 ratio will inevitably have a lot of losing trades – provided you can soldier on through some serious losing runs, keeping the faith when the winning trades are far apart – it can be a successful strategy.

And I’m not exaggerating on the losing runs here. If you have a success rate of 25% (i.e. you anticipate only winning 1 in every 4 trades) – there’s a 91% probability that you’ll experience a run of 10 losing trades within a 50-trade period.

And that can seriously dent your confidence.

Personally, these kinds of ratios don’t suit my trading style or my personality. I simply don’t like losing trades that often – I know that I should be able to rise above it, but it drags my trading down, and I become pestered with nagging doubts.

I’m a lot more comfortable with lower reward ratios, and higher success rates.

These are the kind of stats that make me happier:
1:3 risk reward ratio requires a 75% success rate to breakeven
1:2 risk reward ratio requires a 66% success rate to breakeven
1:1.5 risk reward ratio requires a 56% success rate to breakeven

Freedom to choose your mode of transport

I’m a big believer in using easy-to-follow trading strategies (it keeps our trading disciplined and on track), but I also know that one size doesn’t fit all. Which is why, when I created Wall St Time-Shift Trader, I wanted to offer traders the freedom to go for a success rate that suits their trading personality.

And that’s exactly what Time-Shift Trader does. If you want to have a high success rate, and lower reward ratio – you can. If you prefer to have a higher reward ratio, and lower success rate – that’s your choice.

What’s crucial is that – whether you go for 2:1 or 1:2 (or anywhere in between) – you’ve still got that all-important edge.

Which means that your trading is going to be profitable.

The system will be launched on 18 October, but is available for members to start trial right now. To find out more, sign up to Trader’s Bulletin newsletter.

Building on success

Once you have a system that has a success rate and reward ratio that you’re comfortable with – and you’re consistently maintaining an edge on the market – then is the time to start building on that. To start pushing that reward ratio higher …

Over the coming weeks, I’ll be looking at staking methods that can help you do just that – squeezing extra profits from a trading strategy.