In order to be a profitable forex trader, you have to either win more often than you lose, win more on each trade than you lose, or better yet; do both. Doing both can be very tricky though and is truly the hallmark of a professional trader. As a new trader, it is probably best to focus on one approach and see where you can go from there. In this quick piece we will discuss the ins and outs of each approach and help you decide which method is right for you.
The relationship between win rate and reward ratio in forex trading
Before we discuss either approach, it’s important you understand the relationship between a trader’s win rate, their reward ratio and profitability. Assuming a trader risks an average of 10 pips on a trade to make 10 pips of profit, they will need to get 50% of their trades right in order to breakeven. If they win more than 50% of their trades, then they will be profitable.
What happens if our trader risks 10 pips to make 20 though? This trader is forex trading with a positive reward ratio and therefore will not have to win as many trades to breakeven, or turn a profit. The opposite is true for a trader who trades with a negative reward ratio ie risks 10 pips to make 5 – this trader will have to win more than 50% of their trades to breakeven and even more to turn a profit. There is an inverse, co-integrated relationship between a trader’s win rate and reward ratio: the larger your reward ratio, the less trades you have to win, and the more trades you win, the less you need to win on each trade.
Forex trading with a positive reward ratio
Forex trading with a positive reward ratio is a good place to start as a beginner, because chances are if you are just starting out, you don’t quite yet have a knack for accurately predicting markets. If you aim to make twice as much as you are risking on a winning trade, your breakeven rate drops all the way down from 50% to 33% and any wins above 33% are pure profit. If you aim for 3 units of risk (3R) on a profitable trade, your breakeven requirement drops even further to 25%.
Sounds easy right? This advice is often offered by market makers with educational arms and though the advice is solid, what they neglect to tell new traders is that it’s actually harder to make 2 x risk (2R) than it is to make 1 x risk (1R). Regardless, this approach is still a great place to start as a new trader, we just believe in an open and honest approach to forex education.
Forex trading with a positive win rate
Attempting to achieve profitability via a positive win rate is generally not a great idea for new traders, as chances are you are not yet experienced enough to get the market right more than half the time. Having said that, as we mentioned above, aiming for one unit of risk in profit has a higher chance of success than aiming for two. The other option is trading with a negative reward ratio, ie aiming for less than a single unit of risk on a profitable trade.
The problem with trading forex with a negative reward ratio, is the more your reward ratio drops, the more trades you need to win to turn a profit. If for example, you only aim for half a unit of risk on a winning trade, your breakeven rate rises from 50% all the way up to 66.67%. On the other hand, there is a higher probability of success on trades with negative reward ratios.
When looking at automated systems and forex signals, you often see systems that appear great because they are forex trading with extreme negative reward ratios. These systems will risk a hundred pips or more in order to make 5-10 pips. This can work for quite a long time, but eventually volatility picks up and the stop losses start getting hit. Every stop loss that triggers wipes out a bunch of winning trades and you start seeing sharp declines in the system’s equity curve. The hallmark of these systems is win rates above 90%, if you see a system with a win rate that high, look a little deeper and examine how exactly this incredible win rate is being achieved.
Source: Vantage FX Blog