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Forex Education: Risk Versus Reward

Forex Education: Risk Versus Reward

2014-02-11 20:14:00
Jeremy Wagner, CEWA-M, Head of Education
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Talking Points:

  • Traders lose because they let their losing trades outpace their winning trades
  • Seek out positive risk-to-reward ratio trades
  • When automating, seek strategies where the average winning trade is larger than the average losing trade

The statistics show that most traders lose money in the markets. We know from our Traits of Successful Traders Research, that there are common mistakes made by the losing traders. We also know through the research what traits tend to lead to more consistent results.

Today, we will highlight the first trait of a successful trader which is to risk a little to make a lot.

Before we get started, we need to remind you that by following these methods, they won’t guarantee you will find winning trades or that you will be profitable. These are general trends found when researching traits of successful traders. (To read the complete research, download the guide here after leaving your name, email, and phone number.)

risk_a_little_to_make_a_lot_body_Picture_5.png, Forex Education: Risk Versus Reward

With each trading opportunity, we will find opposition. That means each trading opportunity has risk associated with it and the possibility of loss. When we find those opportunities where the reward is significantly larger than the risk, those are good risk to reward ratio trades.

The first trait of a successful trader is to seek out positive risk to reward ratio trades such that if wrong, little is at risk. However, if we are right, it is a large winner. Traders, who consistently seek out positive risk to reward ratio trades, where their average winner is greater than their average loser, tend to see more consistent results.

Traits of Successful Traders Who Automate

In the context of an automated strategy, the computer is out searching for buy and sell signals. The strategy already has programmed into its code when to enter and when to exit. Therefore, the easiest way to determine the strategy’s risk to reward ratio is by analyzing the average winning trade and comparing it to the average losing trade.

As we can see below, we have 2 different strategies looking back for a six month period. In the first image, all 10 of the currency pairs shown have a higher average winner (APT = Average Profitable Trade) versus their average losing trade (ALT = Average Losing Trade).

risk_a_little_to_make_a_lot_body_Picture_3.png, Forex Education: Risk Versus Reward

(Data taken from FXCM’s Mirror Trader Platform.)

The second strategy consistently has a larger average losing trade relative to the size of the average winning trade.

risk_a_little_to_make_a_lot_body_Picture_4.png, Forex Education: Risk Versus Reward

(Data taken from FXCM’s Mirror Trader Platform.)

(The data for both strategies above were pulled from FXCM’s Mirror trader platform. Register for a Mirror Demo account to see and trade the data on over 40 different strategies.)

Average Winner Versus Average Loser, Really?

By itself, the average winning trade size relative to the average losing trade size does NOT indicate anything about profitability of the strategy. However, it does indicate how much we win when we are right versus when we are wrong. That essentially provides us with a behavior of the strategy that we can use when deciding what strategy to trade.

For example, let’s assume that you are a trend follower. You identify the strongest trends occurring in the market, then filter trades in the direction of the trend. Upon analysis of your average winning trade versus your average losing trade, you realize that your winners were smaller than your losers.

If your analysis says a certain pair is in a strong trend, why cut your winners short? One benefit of trend trading is that there are more pips available in the direction of the trend rather than counter trend. Therefore, give the winning trades more breathing room to advance while limiting your losses.

The same concept applies if you are mirroring a strategy.

For example, both strategies noted in the images above trade the CHF/JPY currency pair. The first strategy has an average winner versus average loser ratio of 138 / 51 = 2.7.

The second strategy has an average winner versus average loser ratio of 119 / 127 = 0.9.

If the CHF/JPY has been in a strong trend, why take on more risk with the losers relative to the winners? That means if the first strategy is a trend loving strategy, the first strategy would be preferred over the second strategy because when it is right, it wins 2.7 times the size of its losers.

Bottom Line

Analyze the size of your strategy’s winning trades relative to the losing trades. Seek out opportunities such that the sizes of your winners are larger than the size of your losing trades.

---Written by Jeremy Wagner, Head Trading Instructor, DailyFX Education

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See Jeremy’s recent articles at his DailyFX Forex Educators Bio Page.

Want to learn more about how to select strategy’s to trade on the Mirror platform? Watch this 8 minute video on selecting strategy with Mirror Trader and you’ll discover an easy method to determine which DailyFX Plus Strategies to trade and the appropriate trade sizes relative to your account size.

The video is on demand here and accessible after you leave your name, email, and phone number.

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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