There is a big difference between a methodology that underpins your analysis and having a simple trading strategy which just tells you when to get in and when to get out. If a trader just has the latter, then your journey can be a bit difficult.
There are two sides to trading. There is the analytical side, where you forecast what the market is going to do. Then there is the money-making side. A lot of traders either skip the money-making methodology. Or worse they combine the analytical side with the money-making side. – This is a common mistake.
Strategy hopping
When the money-making methodology is not in place, many traders fall in the trap of strategy hopping. They simply blame their strategy. They learn a strategy, it works for a certain period. Then it stops working or they realise it’s not making them money directly. So then what do traders do? They search for a new strategy, this time they are pretty convinced this is the money maker! However, this is not the case. I will soon focus on this specific topic on why traders move from one strategy to another and most chances those strategies would’ve worked if adopted with correct risk management methodology.
For example, here at Elliott Wave Forecast we practise the Elliott Wave Theory (EWT). A theory that was discovered by an account called Ralph Nelson Elliott in the 1930s. EWT in my eyes is not a trading strategy but only an academic tool to forecast the market. We have other confluences that we use such as correlations and specific indicators to help us spot divergences. But in order to capitalise from the markets, we have our own specific rules such as entries, exits, stoploss placement and risk management.
Why does Elliott Wave Theory work?
The Elliott Wave Theory is just a very useful language. A language that not only helps us figure out whether we are in a trending-based move or a corrective move but it helps us identify what stage we are in that specific trend. If the price is correcting, the theory has a list of patterns that be in play and we love the flexibility of identifying patterns in the market.
The theory has 3 rules that we abide by and I cannot not remember last time explaining a market move without using the rules. 1, Wave 2 cannot exceed wave 1. 2, Wave 4 cannot go into wave 3. 3, Wave 3 cannot be the shortest wave.
Risk management
Risk management is a very important element of successful trading psychology. You need a sophisticated and strong risk management protocols in place to exhibit the right behaviour and make correct decisions on a regular basis. Risk management in today’s education only explains on risking 1% to 2% of your account or having a 2:1 risk to reward ratio and just sticking to those rules. That’s one aspect to risk management but its not all there is to this subject. Most traders think their problem is strategy, or if they can read the market better but the problem often is failed traders fall in trap of having no appropriate risk management methodology.
High win rate vs. high risk to reward – spoiler: you can’t have both.
Now this does not mean if you have a high risk to reward ratio overall that you will have a low win rate, it just will not be as extremely high as opposed if you have a medium average risk to reward per trade, but your win rate probability will gradually increase, I will explain below on whys and hows and you will see how they are inversely correlated.
High Win Rate
I like to trade the FX market based on the current medium-term trend the market is presenting to me, so I look for trend continuation once we reach the maturity of the corrective way. To achieve a high win rate, the trick is to place your stoploss in an area that if this level is hit, your trend analysis is incorrect, therefore with this methodology, you have provided your trade enough space to breathe. For example, with us we place our stoploss at 1.618 extension of Zig Zag pattern’s wave A. Our entry would be based on equal leg.
This has proven successful within our analysis as not only we give the market space to breathe but our entries are based on Elliott Wave’s guidelines. We personally prefer a high win rate.
High Risk to Reward
If you are seeking a higher risk to reward, be ready for a somewhat medium win rate, probably around 50%, but at least your R:R is high, this method depends on your appetite. When using this specific stoploss methodology, you are essentially trying to spot the “top” of the corrective wave, so therefore your stoploss would be right above the corrective wave’s extreme. If the trade is successful, then you will receive a handsome profit, but you will be reaching that stoploss often.
Wrapping it up
As you can see, risk management is just more than just a percentage or JUST having a positive R:R:R. It’s about your personality on a deeper level and what your preference is.
Me personally, I prefer placing my stoploss in an area where I know my analysis was not successful. With that I would still receive a good R:R:R and my win rate is good. However, as my trade progresses and forms a new low or the base of the corrective pattern, I tend to then manage my risk on the go by placing my stoploss above the corrective pattern, at that point it would be considered as the previous high.
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Source: Inverse correlation between a high win rate and a high risk to reward