As every trader knows, there is no guarantee the market will go the way you expect it; even if you have the best strategy, and the best fundamental understanding of economics and finance – there can still be an unexpected event that comes along to throw the market in disarray.
Ultimately, you are considering the relative likelihood that the market will go your way. This varies from strategy to strategy, but realistically, it is nowhere near 80% accurate (much less in the 90s percentage). A famous stock trader in the 80s once remarked that if he was accurate 55% of the time with his trades, he’d consider himself doing really well.
Strategy is more management than entry
So, getting a good strategy is, of course, important, but is secondary to measuring your exposure to the markets from that strategy. This is why it’s vital to backtest any strategy so you can estimate how often you are realistically going to be winning and losing on your trades.
If you are going to be a successful trader, presumably you will be trading for years to come; and that means you are going to be making lots of trades – even if you are only trading on the daily chart.
As we discussed previously, betting on one trade being accurate, instead of considering all the trades you will be making over time is called gambling. While that can be fun, the bottom line is that the market is the house – and the house always wins.
Profitability ratios are your guide
To turn your strategy from gambling into an investment, you need to consider the accuracy of the strategy over time and compare it to how much money you can risk over that time. This will give you a profitability ratio.
If your strategy has an accuracy rate of 60% (which is quite good), this means that if you do ten trades, six will be profitable and four will be losses; giving you a profit loss ratio of 6:4.
Don’t forget trading sideways
A quick side note, you’ll often see articles and books on trading discussing profit and loss, but they will largely ignore the third option: flat. What if you close your trade out at the same level as you entered? Generally speaking, this has no impact on your balance, so a lot of authors will simply ignore them. They have virtually no impact on your strategy.
However, a flat trade has an impact on your money management; because even if you don’t lose or make money on a trade, your money is still tied up in the trade for a period of time.
So, while it doesn’t factor into your profit loss ratio, it does need to be considered when you calculate how much money you are setting aside for trade, and how the interest spread will impact you.
How much will you make, not how much you could make
How much could you make on a trade? Well, if you’re shorting the Yen and it just happens that North Korea launches a missile at Tokio… you *could* make in the range of thousands of pips. But, that’s not likely.
With a 6:4 profitability ratio strategy, if you make 100 pips on every winning trade, and lose 100 pips when the market goes against you, then after ten trades you will have made 200 pips. It means you could lose up to 400 pips before you become profitable – which means you need to have enough money in your account to cover for that potential loss.
Of course past performance is no guarantee of future performance, and there is always a black swan. But, the point is that trading is based on a series of trades over time, and that by considering the potential loss and profit over time instead of on individual trades, you get a better handle on how much you should be investing in each trade. You should also be consider how much you need to keep in reserve – as well as how much money you will actually make (instead of hope to make).