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The Counter Intuitive Nature of Risk/Reward Ratios
What’s better -- taking many trades that have a reward to risk ratio of 1 to 5 or taking many trades that have ratio of 5 to 1?
Would you rather make many bets that pay 1 and risk 5 or many bets that pay 5 and risk 1?
If you answered the latter you’d be dead wrong.
On the surface the idea of making many trades that have a positive risk reward profile looks immensely attractive. Who wouldn’t you want to get paid 5 every time you risk 1? Unfortunately many traders confuse the idea of payoff with the probability of actually collecting those payoffs. The probability of consistently making a trade that makes you 5 while keeping risk to 1 is generally very small -- MAYBE 15% if that.
One time I was in the green room with a very well known currency analyst who pompously announced that he doesn’t take trades that are less that 4 to 1. Right then and there I knew the guy never bet his own money in his life and was just a glorified paper trader like most Wall Street analysts are.
Assuming you have a long term positive expectancy (i.e. say you lose 3 for every 1 you make, but your winning percentage is 77% or better) you should do as many trades as possible for the same reason that insurance companies write as many policies as possible -- the law of large numbers works in your favor. As long you keep each individual trade loss to a very small risk size (between 0.5% and 1.0%) your risk of ruin is manageable. The more you trade the more profits you’ll build up the more capital you’ll have at your disposal to survive the drawdown.
The high reward/low risk trades have the exact opposite profile. You spend a lot of time bleeding away money until you finally hit a good trade. Worse, since good trades are rare -- your chance of missing them is very high as you can’t watch the markets all the time. Lastly the psychological toll of constantly losing money makes traders much more reluctant to pull the trigger just at the moment when they need to.
That why when you study all the great hedge fund manager who trade with high reward to risk ratios you notice one thing that most retail traders miss -- they are highly selective. From Soros to Tudor Jones many of the great traders will make a few forays into the markets and take quick losses but will pounce on the opportunity when it goes their way. To do that they are perfectly happy to be very patient and select their targets after massive research.
Retail traders on the other hand will trade blindly using high reward to risk ratios because that what they’ve been told and then wonder why they are losing all their money.
So the lesson of the day is if you trade like an insurance company don’t be afraid to write a new policy after a hurricane wipes out your profits but if you trade like a hedge fund -- you better know exactly what you are doing.