I am trying to wrap my head around the full implications of this statement:
Mathetically:
If your risk:reward (5:1) and loss:win (1:5) ratios are reciprocal values, it’s a break-even system (less fees/auxilary costs) with a profit factor of 1.
Therefore:
If you can repeatably achieve a higher win:loss ratio than risk:reward ratio, you have a profitable system.
My question:
At what point does a profitable system become an edge? (And did I get the first part right?)
There’s more context in my original question, if you want to see my line of thought.
My honest opinion is to forget about risk to reward. Don’t look for a certain return from a trade because it’s uncanny how often it gets close and turns around to a loser.
When you enter, work out where you want the stop loss to be based on the chart. Risk say 1% or less at first. When your trade moves in your favour, bring the stop loss up. Typically I’d say when I’m more than 20 points in profit I go to break even. Then use the charts and how price is changing to exit when you think you’re at a good point on the chart.
Your reward is unlimited, but your risk is small. If you catch a move that has all the signs of a runner you can add to it as it breaks or retests levels.
The more you watch the markets, the more you get a feeling for when it’s going to turn and you need to get in or out. Once you master entries, you’re very rarely risking anything because you can move to break even quickly.
If I’m not at break even in less than 5 minutes, usually I’ll lose because I got it wrong. But don’t close early, if your system said buy then it might turn around and just needed the liquidity grab for a big move.
Btw I only trade indices so this might be dog poop on forex. I wouldn’t trade forex, too manipulated. Although Trump is probably doing more of that than anybody in history right now
You’re mostly on the right track, and I like how you’re thinking critically about risk:reward vs. win rate.
Now, where it gets interesting is your last question: When does a profitable system become an edge?
A profitable system just means over time you’re making more than you’re losing. But an edge implies consistency, repeatability.
A profitable system becomes an edge when you can clearly define the logic behind why it should work ,repeat the setup over many trades with similar conditions,and stay profitable across changing market conditions.
What seems quite simple, is so complicated in real life.
You also need to factor in the spread and commission, so even if you have an “edge” from paper trading, in real life it might not be the case.
I’ve done a LOT (several hundred trades, probably close to a thousand now) of back testing various strategies and risk to reward can be the difference between a profitable strategy and a losing one.
This is for sure, and it’s a point that many people seem not to understand at all (and dare I say some of them seem even not to want to understand it, either!).
I’ve ran the simulations with real ticks from my broker, sample sets consisting of 10,000+ trades on EurUsd. There is no advantage of using any R:R when it comes to win % as win rate will correlate directly to the R-multiple.
There is a disadvantage using R-multiples higher than 1, as they will always have greater losing streaks than winning streaks. Closer to 1, the more evenly they’re distributed.
It’s not the win/loss % that kills accts. It’s the length & distribution of losing streaks. Eventually the 5R (16.6% WR) strategy will come across a losing streak of 15-20 to kill the acct… or make the trader question everything, switch strategies, looking for answers. Even worse, is when the 5R wins back to back or 50% of a small sample set, then breaks down back to its expected value in the form of a large losing streak.