Trading - Win To Loss Ratios & Risk To Reward Ratios
Technical trading systems that work usually have either excellent win to loss ratios winning considerable more times than they lose, or excellent risk to reward ratios where the average winning trade is considerably larger than the average losing trade - very rarely does one come across a technical trading system that has both.
Trading systems with both win to loss ratios considerable greater than 50% and risk to reward ratios well above 1 to 1 are rare and tend to only achieve these results by either using very long time frames, or by only trading a few specially selected markets when a fairly rare event happens. Some examples of these systems would be the long-term trend following system Strange Currencies that enters on a close above or below a 120-day high or low, and the GBP/USD Momentum Trading System that only trades on a fairly rare event in the Cable market, the rare event being a move bigger than any movement in the last 10 days. These systems work well but just don't provide many trading opportunities and spend a lot of the time out of the market.
Systems with high risk to reward ratios,
Systems that produce winning trades that are far larger than the losing trades usually do this by trend following, following the trend and holding the position until the trend has completely ended is the easiest way to produce very large wins from a single trade. Unfortunately, trend following systems are usually wrong more often than they are right; this makes these systems very difficult to follow as a string of losses grinds the trader down whilst they are waiting for the elusive big move that rarely happens. Trend following systems usually lose more often than they win mainly because of the exits. The goal of a typical trend following system is to enter in the direction of the main trend and hold the position until the trend ends. This means that mechanical trend following systems don't actually produce an entry signal until the trend has already begun and don't produce an exit signal until the trend has already ended and reversed. Usually the trend doesn't run for long enough after an entry signal to make up for the losses that occur when the trend reverses and the system is waiting for an exit signal, especially when the system is trading on a relatively short time frame.
Long and short trends: Short trends usually result in losses as they don't continue for long enough after the trend is initially detected to make up for the losses that are incurred waiting for an exit signal after the trend reverses.
Trend following systems tend to work best on large time frames as only significant trends result in profit on these systems and the longer the time frame the more significant the trend. The more significant the trend the longer it is likely to last -
A 5 day/10 day simple moving average crossover system. The system produces lots of whipsaws (losing trades) before one big, profitable move, which is immediately follow by more losing trades.
A 10 day/20 day simple moving average crossover system. The system produces less whipsaws (losing trades) than the 5 day/10 day SMA crossover system.
A 20 day/40 day simple moving average crossover system. The system produces less whipsaws (losing trades) than both the 5 day/10 day SMA crossover system and the 10 day/20 day SMA crossover system.
Using a suitable time frame is the best way to avoid whipsaws as the larger the trading time frame, the more significant the trend and the less likely it is to suddenly reverse. Good exit strategies are also very important. A bad exit strategy will either get you out of a good trade before the trend has ended or out of the trade long after the trend has reversed. One of best exit strategies I have come across is to exit on lack of follow through (I define lack of follow through on a trend following system as a failure to make a new high or low in X number of days); I used this type of exit strategy in the Strange Currencies trading system.
Another strategy novice traders often use to try and ensure that the winning trades are larger than the losing trades is using 'tight' stop losses. I strongly advise against doing this. Stop losses are essential, but they must be suitable stop losses that give the trade room to 'breath'; even a strongly trending market never moves consistently in the same direction so using to tight a stop loss will degrade the performance of any trading system. What is and isn't a suitable figure for a stop loss depends mainly on the market's volatility, but a good rough figure for a stop loss to use as part of a trend following system might be around several times the market's Average True Range.
Systems with high win to loss ratios,
Systems with high win to loss ratios usually achieve these results in one of two ways, both of which are almost polar opposites of trend following.
The first method these systems often use is profit targets, trend following systems usually aim to 'ride the trend until the end' which results in big profits from a few trades and small to reasonable sized losses from a lot of trades. Using a profit target or a time based exit however tends to have the reverse effect, most trades win and the few that don't have to be cut off with a suitable stop loss to stop the losses getting out of control.
The second method technical trading systems often use to have more winning trades than losing trades is selling (shorting) when the market is high and buying (going long) when the market is low. Again these trades are usually right, but suitable stop losses are needed to stop the losses from the few losing trades getting out of control.
If you are planning to develop a trading system that has a high winning trade to losing trade ratio by targeting a certain profit level or by fading (going against) a short term moving average it is very important to use hard stop losses to cut of the losers as they will get out of control.
