A lot of your trading system and position sizing will depend on what your win rate is and what your reward to risk ratio is.
Pretty simple statistics eh?
Steve Cohen, the billionaire hedge fund manager uses simple statistics as well. In the CNBC article: How SAC Capital Works Now, Cohen says:
We keep score with simple stats, like baseball. You obviously want your winning trades to make more money than your losing trades lose.
The article then goes to say that his traders are judged on two basic measures: Their win/loss percentage and their relative sizes of their wins and losses.
There are different order flow systems that you can develop and trade. Some of them have a high winrate of 70% + but low reward risk ratio with the winners only making around 1-3 times what you risked.
Other order flow systems have low/average win rate around 30-60%, but the reward risk ratio is extremely high with the winners making over 4 times what you risked.
Then there are the truly extraordinary trading systems that have BOTH high winrates and high reward to risk ratios. These are the ones where you can go for the jugular on. Soros knew about this when he broke the Bank of England and took full advantage of both the perceived high winning percentage and high potential payoff.
There are important distinctions between each trading system that you need to be aware of. There are certain market principles that if you try to defy them, the market will just smash you by giving you many losses, big losses, or blowing your account.
High Win Rate, Low Reward To Risk Systems
These types of trading systems can either be traded with low percentage risk, or high percentage risk. Since these trades are high winrate, they may not occur as often. Therefore if you choose to only trade them with low percentage risk, you may not be getting the most bang for your buck.
Also since their reward to risk ratio is low, trading them with low percentage risk is not going to make you that much money.
For example, lets say you have a high winrate, low reward to risk ratio system, with 90% winrate, 1:1 risk reward ratio.
If you only trade such a system with 0.50% risk per trade, then you are only making a maximum of 0.50% per trade. You can’t make any more than that on the trade because the system has a low reward to risk ratio ratio. The strength of the system isn’t in the big winning trades. The strength is in the large number of consecutive winning trades. The consecutive profits.
Therefore, with such a system you may want to attempt to trade the system using higher risk per trade than 0.50%. For example if you traded the same system with 10% risk per trade instead of 0.50%, then assuming the same series of trades, your trading performance and return will be far higher.
Of course you run the risk of suffering a loss on your first trade and being down 10%, which is not desirable. But the high win rate of the system should compensate over the next series of trades.
Trading systems with high win rates are desirable and generally preferable because of the low probability of suffering consecutive trading losses.
These are the types of trading systems that are usually used if you want to quickly grow an account from five figures into the six figure range or 1 million dollar range. Once you get into the million dollar range liquidity constraints and protection of your capital become more important and you ratchet down your risk per trade.
When you have taken a five figure account to a million you don’t want to be risking too much per trade. You don’t want to bet your lifestyle.
The only goal of using high leverage and high risk per trade is too get your account up to a high enough level where you can ratchet down your risk per trade and still achieve meaningful sums of money.
Low/Average Win Rate, High Reward to Risk Ratio
These are the types of trading systems that most traders are attempting to develop. Your typical technical indicator or chart pattern trader is attempting to develop a system with around 30-60% winrate, but with the winners being very large to compensate for the losing trades.
There is nothing wrong with these types of systems. I trade these systems as well.
Since your win rate is lower, your probability of having consecutive losing trades is far greater. Since your probability of suffering many losing trades in a row is greater, you HAVE to use low risk per trade.
Attempting to trade these systems using high risk per trade will turn out to be a disaster. You may catch a nice winner, but the volatility will be hair raising.
Lets say you have a system with a 30% winrate, and your winners are six times what you risked.
If you decide to trade using 10% risk per trade, then you may get lucky and catch a winner on your first trade. If you do your account is up 60%. If on the other hand you catch a series of consecutive losers, then your account will start to drop 10% each trade. And since you only have a 30% win rate, you can suffer 3, 4, 5, or 6 losing trades in a row. If that series of losers happens before your first winner, you could be down 50% of your account before you see your first winner.
Which is why these systems are only designed to be traded using low risk per trade. You can only unlock the true potential of these systems if you use a low risk per trade.
Low win rate systems necessitate low risk per trade amounts. That is the cardinal rule.
High win rate systems do not have to necessitate high risk per trade amounts. You can easily trade a high win rate system using low risk per trade and still get respectable numbers. However, if you want to unlock the true potential of a high win rate system, then you have to set a pot of capital on the side and trade the system using high risk per trade.
High win rate systems necessitate high risk per trade amounts if you want to unlock their full potential.
High Win Rate, High Reward to Risk Ratios
These types of trading systems are some of the coolest around. These are the types of trades that you dream for in your career. These are the times when you can go for the jugular on them.
These are the types of trading systems where you can have a 70%+ win rate, yet still have an extraordinarily high reward to risk ratio with the potential payoff being over five times what you risked.
These are the types of trades where you can make 50%, 100%, or 200% in a single trade.
These types of trading systems are very rare and do not fire off a signal that often. But when they do, you should take full advantage of them.
These types of trading systems do not have to be traded with high risk per trade. You can do fine trading them with low risk per trade.
However, if you want to get the full potential out of these trades then you would need to use high risk per trade.
Frequency of Trades
I have trading systems for all of the above. They are all highly discretionary but still are systems nonetheless.
You need to realize the frequency of the trades to be expected.
The trading system that fires off the most signals is the: Low Win Rate, High Reward to Risk System.
The trading system that fires off an average amount of signals is the: High Winrate, Low Reward to Risk System
The trading system that fires off the least amount of signals is the: High Winrate, High Reward to Risk System.
It makes sense right? The system that fires off the most signals is the one with the lowest profit potential. The system that fires off the average amount of signals is the more profitable trading system. And finally the system that fires off the least amount of signals is the most profitable one.
I trade the low winrate, high reward to risk ratio systems and they keep me occupied and busy while I await for the chance to go for the jugular on the high winrate system trades. That is my trading philosophy.
What systems do many large hedge funds trade? Many of the hedge funds trade using the low win rate, high reward to risk ratio systems. Part of the reason is that they don’t know how to capture the better trades. But the bigger reason is that they are trading with much bigger positions to the tune of hundreds of millions and billions of dollars, thus the type of trading system that can accommodate such liquidity constraints and still generate a decent amount of signals is the low win rate, high risk reward system.
Also note that if if you attempt to trade any of the above systems with a large amount of capital, then you probably either destroy the profitability of the system because the market cannot handle it. Or what will happen is you will reduce the frequency of trades within that system to only the ones that can handle the large amount of capital.
For example if you have a trading system that has a 80% winrate, and winners are three times what you risked. It generates 25 signals per year. It generates 25 signals per year if you are attempting to trade it with a small/moderate amount of capital, of lets say $1 million.
The moment you decided to trade such a system with a large amount of capital, say $1 billion. Either you will destroy the system. Or, what is more likely is the number of signals generated per year drops. So if you had 25 signals per year trading the system with $1 million in capital. If you trade the system with $1 billion in capital, taking into account the new liquidity constraints and impact of larger orders, you may only get 10 trading signals per year.
How do I know these things?
I just know.
Notice that I did not mention anything about the low win rate, low reward to risk ratio system, nor anything about the high winrate, with reward to risk ratio below 1:1. I didn’t mention them because those systems are not worth trading.
There is no reason to be trading a system that has 80% win rate and a Reward to Risk ratio of 0.50
There is no reason to be trading a system with a 30% winrate where your wins are only two times your losses.
Don’t trade those systems.
Instead develop better trading systems.
I hope you enjoyed the article.
Transform your trading with Order Flow Mastery. Click Here.