Probability

Probability tells you how often your trade is successful. A 20% success rate, tells us that for every 100 trades you place, you expect 20 of them to be profitable. An 80% success rate means that for every 100 trades you place, you expect 80 of them to be profitable.

You can have yourself a trade with a 4:1 risk-reward ratio, but if it only wins 20% of the time, it won’t take you very far.

However, if you have a trade with a risk-reward ratio of 1:3 (i.e., you’re risking £30 for every £10 potential winnings), but it has success rate of 80%, you’ll be profitable.

As you can see here, all the well-balanced risk-reward ratios in the world, won’t make your trading successful, unless you have carefully balanced it with probability.

The psychology of success rates

We’re often told as traders that we need to take the losses and the winners with the same degree of emotional detachment. We mustn’t let losing trades get us down … we need to just keep chugging along the straight and narrow, rolling with the punches.

But we’re not robots …

No one likes losing.

Many, many trading strategies will lose more than 50% of the time. Some of these may be profitable, but these traders are still ‘wrong’ most of the time. And the lower your success rate, the longer your losing runs will go on for – they can feel interminable, leaving you in serious doubt about the strategy you’re using.

Let’s look at these examples:

Trader A has a 7:1 risk-reward ratio, combined with a success rate of 15%. For every £1 he risks, his potential reward is £7. And for every 100 trades he places, he should be winning 15 of them and losing 85. The net result is: for every £85 he loses, he should be rewarded by £105 – a net of £20.

However, bear in mind, that Trader A will be losing 85% of his trades. Add to that a nasty run of losers, and he can very quickly feel completely disheartened. And, if he misses out on one of his rare winning trades (by making a mistake or missing a signal) – he’ll be seriously set back.

Trader B, on the other hand has a 1:3 risk-reward ratio. So, Trader B will win just £1 for every £3 risked. This would be thrown out of the trading books by some – “Just too risky” they would tell you.

However, if Trader B can combine it with a probability of 80%, I believe that more often than not, he’ll beat Trader A.

Out of every 100 trades, Trader B expects to win 80 and lose 20, so the net result is that for every £60 he loses, he should be rewarded by £80. – a net of £20.

On paper, it looks like Trader A and Trader B are pretty evenly matched on profitability. However, there are few traders I know who can take a 15% win rate with the kind of disconnected attitude it requires. If you’re losing 75 out of every 100 trades – it’s going to be hard to maintain a positive attitude to your trading. Add to that a bad run (we all get them) – and I expect that most of us would lose faith in our trading strategy altogether.

That’s why I’d always recommend a strategy with a high success rate combined with a modest risk-reward ratio over a strategy with a great risk-reward ratio and a low win rate.

Quite simply – it’s just better suited to human nature.

Testing your limits

The important thing with probability is to view it as part of the whole profitability picture, and to make a judgement on the kind of risk-reward you expect from your trading.

If you can deal with interminably long losing runs (as long as you get profitability in the end) then you’re made of sterner stuff than I am! As with many aspects of trading, understanding your own limitations is all part of the process.

So, now that you’re up to speed on risk-reward and probability, it’s time to get to the point … the reason we need to know these things is so that we can understand the next word you need to know … Positive Expectancy …

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