I’ve been reading Curtis Faith’s new book Trading From Your Gut, a review of which will follow shortly when I finish. The part I was going through this morning on my commute into work, though, inspired me to address the subject of win rate and good trading. Faith hits hard on the subject, which is one I’ve addressed on a few occasions myself.
Here’s the deal. Traders, especially newer ones, get way too hung up on being right and having a high win %. This comes from two underlying causes. One is the fear of being wrong. The other is the belief that one needs to have more winning trades than losing ones to be successful in the markets. Both are problematic and will cause trouble.
The need to be right is something which kills traders. As Faith puts it, the whole being right thing is for forecasters and prognosticators. Traders who get fixated on being right make very, very bad decisions sometimes – ones that potentially can blow up their account. They are the traders who hold on to losing positions way too long in hopes they come back because they can’t handle the idea that they were wrong and will have to take a loss. Of course that often leads them to eventually panic at some point and bail on a trade at exactly the worst possible time (as many stock traders did in March 2009).
The need to have a high win rate also encourages such silly trading behavior as “hedging” in the forex market. I’ve heard many a trader justify their taking an opposing position in the pair that is trading against them as letting them stay in the trade so it can eventually turn back in their favor. They seem to be ignoring the fact that all they’ve done when putting on a “hedge” like that is to lock in their loss. Like I said, poor decisions – ones based on emotion.
Then there are those who think that in order be a profitable trader you must have more winners than losers. Of course this is true if your winning trades are the same size as your losers. If, for example, each trade will either be a $100 gain or a $100 loss, then you need to win more than 50% of the time to expect to come out ahead in the long run. It’s a straight forward mathematical relationship. If you win 51% of the time then the expectancy for your trades is $2 ($100 x .51 – $100 x .49), meaning that on average you would expect to make $2 for each trade you do.
We can use the same math to demonstrate how you can also be profitable in the long run with a much lower win rate. Let’s use 25% as an example.
Keeping the same $100 gain/loss as above, we come up with a -$75 expectancy ($100 x .25 – $100 x .75). Not good. No big surprise there.
What if we change from a 1:1 winner-to-loser ratio to a 5:1 ratio, though? Let’s call that $500 for the winning trades and $100 for the losers. Running the figures we get an expectancy of $50 ($500 x .25 – $100 x .75). Not bad at all.
In general terms trend trading methodologies are the ones that tend of have low win % but high winner/loser ratios because they have a lot of small losses thanks to whippy, trendless markets but relatively large winners. Other systems go the other way, with lots of small winners and only occasionally a loser, but a big one.
Even for those with no real issue with being “wrong”,Â low win rate systems can be a challenge. They tend to be subject to lots of big equity swings because the high number of losers creates lengthy drawdowns. Those can be very hard to ride out, especially for someone who hasn’t developed confidence in their system.
The bottom line is that you should be focusing on making good trades not on making winning trades. Good trades sometimes lose money, but if you keep making them within the scope of a positive expectancy system or methodology you’ll end up ahead in the long run. Getting caught up in trying to make winning trades will almost certainly end up leading to disaster.