Do you have the right return

Tuesday, September 14th, 2010 Market Analysis by Titus Davis

You may or may not have ever thought about your RR when a trade is taken. When I first learned how to trade I knew nothing about it. I was risking 80-100 pips to make 10, 20 or 30 pips and thought that was normal. Put you stop above/below support or resistance and get paid. It worked for bout 3, 4 trades but one failed trade and my account is below break even. God forbid that next trade fail, if it did I would now have to take 4-5 trades that HAVE to pay perfectly just to get back to par. you can see how this can affect your account significantly.

Negative ratio:
I personally think there is no way you can be profitable over time with a negative ratio like stated above. -5:1 return (risking 100 pips to make 20) is just not wise. Lets think about it this way. If I said “I got this perfect investment idea. Its going to cost you $1000, you might lose all of it, but you can make $200.” Does that even make sense, even COMMON sense? Not to me, at least not any more. lol. With a negative ratio you have to be right 100% of the time to be successful.

1:1 ratio:
Ok, now we are talking, kinda. A 1:1 return is not bad at all.  ”I got this perfect investment idea. Its going to cost you $1000, you might lose all of it, but you can make $1000.” I can manage that, but the questions that arise are:

How accurate is the trade?
Do I have to take every trade when it sets up to be profitable?
What is the success rate of the trade?

To be profitable on a 1:1 risk trade you need to be around 51%. Not to say this isn’t possible or that there aren’t trades like this, but you have to be pretty spot on. What if you have to scale out of a position BEFORE you hit 1:1? Now if you have a 35 pip stop and have to take profits at 20 pips, that just made it a negative ratio trade instantly.

2:1+ ratio:
Now we’re talking.  ”I got this perfect investment idea. Its going to cost you $1000, you might lose all of it, but you can make $2000+.” The only time I came close to this in the real world was when I did real estate. Buy a house, put $10k into the deal and walk away with $20k+ when the house is sold. That is right up my alley, I understand those returns. How does this relate to trading? Well, with a 2:1 ratio you only have to be right 33% of the time to be profitable. Think about that.

W L L          W L L          W L L         W/L = w (small win, but a win none the less)
+20-10-10   +20-10-10    +20-10-10  +20-10= +10

I hope the above makes sense. We have ten trades here, 3.3 winners and 6.7 losers. Because the losers are half the size of the winners, it takes two failed trades to bring the account to break even. So at the end of ten trades the account is still profitable which is all that matters at the end of the week, month or year.

Hope this shines a little lite on trading ratio’s. Hope you are in the right area.