Posted on: 07 Nov, 2018
In this guide, I will introduce the most essential areas you must understand to achieve success in trading.
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While a myriad of components will also have a bearing on your attempts to succeed in this endeavor — trading is a holistic arena with many elements to take into account — without these four pillars, making profits in the market in a sustainable manner can be a rather unrealistic undertake. Note, by sustainable I mean an annual equity curve that shows a clear upward slope as in the case of the illustration below.
So, let’s get into the nuts and bolts. The four pillars that you must be able to combine include win rate, risk-reward, money management, and your broker. These should be the building blocks or pillars as we’d refer to when it comes to your approach trading the markets.
Any strategy, mindset state, goal resolution, preparation, whatever it is that you will incorporate on top of your trading arsenal that fails to understand these universal truths in an activity so statistically-oriented as trading is, will suffer from voidness at its core.
As a trader, you must be able to figure out a realistic yet high enough win rate, so that when it’s combined with the risk-reward, that is, how much you will make in a winning vs the potential loss, the result is a positive expectancy over a sample of trades large enough.
However, that’s easier said than done, and to achieve such level of mastery on your results, one must start by detaching from the idea that a high win rate of let’s say 70% will keep you on the winners’ side if it’s not supported by a high enough risk pay-off whenever you are right.
I can understand the allure it has when reaching a high win rate in trading. After all, it’s only human nature wanting to be right and avoid the pain of enduring a loss. The intensity of emotions when experiencing a loss tends to be greatly amplified as a function of our inherited physiological reaction as humans and originates from the self-defense mechanisms we’ve built over millions of years to escape danger or harmful events.
Therefore, first and foremost, as traders we must break away from this mindset of damage prevention, and start realizing that at the very root, when trading, each outcome represents a constant sequence of random events. It’s only when taking consistently repetitious actions to enter the market through a particular price formation or pattern, that one can tap into the power of what’s often referred to as an ‘edge’, which is nothing more than a positive expectancy over a large sample of trades.
What this means is that the mentality of any successful trader must go through a paradigm shift, one that as humans we are not accustomed to.
We must start thinking in terms of probabilities, not running away from losses but embracing them as part of the statistics, and be at peace as just one more outcome within a broader context of applying a strategy with an edge to exploit.
While it’s not my purpose to get into detail of what constitutes an edge in this article, in a nutshell, it means that one has back-tested a particular entry technique to such an extent, that you can then come to back up one’s assumption by data in order to generate a positive expectancy over a large sample of trades placed in the markets.
A perfect analogy is playing the roulette in the casino. The house knows that every single spin of the wheel the ball may end up landing in any random number, therefore each individual result is an unpredictable outcome. However, the number 0 is what makes the game of the roulette such a profitable game for casinos, because, over a large sample of events, the statistics will tilt the balance in favor of the house.
That’s the type of mentality that as a trader you must have, which brings me to the next point. In each random sample of outcomes, one can and will go through clusters of good and bad luck, so the sooner you accept this reality, the more mentally prepared you will be to tackle trading from the right mindset perspective.
As an example, let’s think about the act of flipping a coin, which is a mutually exclusive and random event, with two outcomes, heads or tails. If you wonder, why in the short-term, such events are considered random despite the theoretical 50/50 chance, leading to accumulating clusters of good/bad luck, you must understand that there is a myriad of uncontrollable factors influencing any outcome in both trading and in a coin flip.
In trading, it can include short-term vs long-term cycles, technical outlook in each timeframe, fundamental events, cluster of orders, etc, while when flipping a coin, the force with which the coin is flipped, motion of the air in the room, position of our hand when we catch the coin, are all elements playing a role in a particular outcome.
In the scenario of a 50% probability for a coin to come up heads or tails, there are up to 16 different outcomes to expect: HHHH — THHH — HHHT — THHT — HHTH — THTH — HHTT — THTT — HTHH — TTHH — HTHT — TTHT — HTTH — TTTH — HTTT — TTTT. What this means, as the table below illustrates, is that in a sequence of events with a 50% probability, we have a 6.25% chance of going through a cluster of luck, good or bad, and end up with 4 heads or 4 tails. Even 2 heads and 2 tails, while still being the most likely outcome, it only has a 37.5% probability, in other words, in such a small sample of events, more randomness applies.
The curve you see above is known as normal distribution or the bell curve, and is one of the most important tools in statistics and probability theory, and also essential to understand for you as a trader. The repetitious trials of random events that arise from flipping a coin results on this bell curve.
Let’s now find out the probability distribution of getting heads in 100 coin flips. Notice how the distribution in outcomes gets more skewed towards the center of the chart or bell shape? This is known as the central limit theorem.
Source: Uses for Math — Everyday Jobs, Sports, Medicine, Solving Crime
What if we kept increasing the number of times we flip the coin to 1,000? The more times we increase N = number of times we flip the coin (times we take a trade), the more pronounced the shape becomes, with the creation of another universal truth in statistics, that is, standard deviations. In layman’s terms, for a sample of coin flips large enough, there is a 68% chance that the result will lie within 1 standard deviation (in blue), while a 95% chance that the result will come within 2 standard deviations (in red).
The bottom line is that a 50/50 random event has a tendency to balance out towards the center of the curve the more the sample increases. And that’s assuming we are flipping a coin, but there are certainly edges one can find through a mentor or experience when trading the forex market with an edge greater than 50% to be found and exploited.
Source: Uses for Math — Everyday Jobs, Sports, Medicine, Solving Crime
To finalize this first chapter, another key point to take away is that the more samples one obtains, the more it decreases the overall percentage of clusters of bad luck, as illustrated in the tables below. If we were to place 10 trades with a 50% win rate expectancy, the expected maximum losing run for the system would be 4, while if we were to increase the number of trades to 100, the maximum losing run would be 7, which is proportionally much less relative to the total trade sample. Therefore, while increasing the clusters of bad luck in relative terms, it largely decreases it as part of the overall net picture, which helps to adjust the bell curve too.
So, accepting as true the hypothesis that a system providing a 50/50 win ratio expectancy tends to increase its accuracy towards its base 50/50 scenario as the sample of trades expands, while the clusters of losing trades (bad luck) also decreases in total terms, what would it take to place the statistical odds in your favor to help you achieve consistency on your results? To answer this question, we must add to the equation the second pillar, one that goes hand-in-hand with the win rate, that is, the risk-reward ratio.
The term risk-reward refers to the amount of capital you aim to make relative to how much you are willing to lose. If depending on your strategy, you seem to struggle to achieve a consistently high win rate above 50%, then the closest thing to the holy grail in trading is to make up for it by making more money when you are right than when you are wrong.
There is a well-known mantra in trading, endorsed by the most legendary traders and investors around the world, which states that as a trader, you must “let your winners run and cut your losses short”. It should be immediately obvious to you why this simplistic yet effective quote has so much power behind. In a few words, the statement encapsulates like no other what the second pillar is all about.
As the table below shows, if one aims for a risk reward of 1:1, in other words, as an example, winning $200 per each $200 you risk, you must be right no less than 50% of the times to keep your head above the water and make money. Meanwhile, if one opts to increase the risk-reward ratio to 2:1, which means you will make $400 per each $200 at risk, even a win rate of 35% allows you to statistically make money.
So, what’s the key? There is no right or wrong approach, as long as you are able to find your sweet spot, one that balances out the win and the risk-reward ratios that can ultimately result in a positive expectancy. A higher win rate allows you the wiggle room to afford a fairly low-risk reward, but if as in the example above, your system’s expectancy achieves a 50% win rate, you must adjust your risk-reward accordingly.
What are these adjustments exactly? Let’s find out by checking the following table, which unpacks the absolute minimum requirements, depending on the combination of win and risk-reward ratios, to break even.
In this chart below, you can visually observe how the need to be right in your trades decreases in proportion to the increases in risk-reward one adopts as part of its trading approach. Finding your sweet spot is a journey of self-discovery, one that will involve trial and error after experimenting your hypothesis and backing them up with empirical data that allows you to make the assumption that a system has XX% of accuracy rate.
Make no mistake. Nothing of what has been written up until this point will be of much practical use unless you treat with respect this little demon called ‘risk’. You must develop a sense of control and almost obsession towards the management of risk, otherwise, the first two pillars of win and risk-reward ratio are likely to be dead in the water.
If one, however, finds the sweet spot as described above, and on top of that, it includes a risk level that is within limits to avoid the risk of ruin, that’s when we finally go ‘full circle’ and create what I like to call the virtuous cycle and by far, the most sacred foundation that any serious trader must abide by.
What exactly is the risk of ruin formula? At its core, the risk of ruin is a statistical model that calculates the probabilities of blowing up your account. Once you have found your sweet spot (win and risk-reward ratios), you now must understand the level of risk you can afford per each trade (third pillar), so that you nullify the probability of losing your account.
Let’s look at a few examples:
Source: Tables provided by Chris Capre, Founder at www.2ndskiesforex.com.
Remember when I introduced the example of a hypothetical strategy with a win rate expectancy of 50% and the trader aiming for a 1:1 risk reward? Well, according to the table above, the risk of blowing up your account regardless of the amount at risk (10% vs 2%) is still the same, 100%. You must find a combination where the risk of ruin is either 0 or low enough for you to accept, but certainly not 100%.
What if the trader decides to utilize a trading system with a 40% win rate but a risk reward of 2:1. Here is where the magic of statistics starts playing out. With a percentage risk of 10%/trade, which is an unacceptable amount, the risk of ruin would be 14.2%, while the same scenario by trading only 2% risk/trade fully eliminates the risk to 0%.
Moral of the story: You must find a level of risk that is appropriate to your first two pillars. As a rule of thumb, it’s broadly acceptable in the industry a threshold of 2–3% per trade as the absolute maximum one should afford, and as the account increase in size, the level of risk tends to logically scale down.
In the following link, Chris Capre from 2ndSkies provides a calculator to find out your risk of ruin probability:
You can throw out of the window the first three pillars unless you find a broker that is on your site, one that provides a service catered to your needs along the way no matter what. A broker that provides an unparalleled customer support and is as transparent as humanly possible.
Without the right companion in your journey to becoming a successful forex trader, the virtuous cycle falls short as a cruel reality of a direct conflict of interest between the broker and the trader settles in. If a broker profits from the losses of the clients, you are definitely not taking sufficient care of one vital pillar. Global Prime, fortunately, aligns its interest with yours.
At Global Prime, we actually provide trade recipes that show which bank filled your order. We are one of the only brokers in the world going the extra mile to such an extreme level of transparency. Our execution services can also be suited to the clients’ particular strategies by applying lighting-fast execution, near zero slippage, deep pools of liquidity and tailored streams for institutional traders.
Besides, the communion we aim to create with our clients cannot be sufficiently overstated, that’s why we make ourselves available around the clock to serve you at the best of our abilities in any questions you may have. We are always opened to hear your feedback to continually improve the quality of service we deliver to our clients.
So, reach to us and let’s get these four pillars into motion. Make this an epic journey to remember. We cannot wait to hear from you and how we can best adjust to your needs as a trader.
Feel free to get in touch with us to find out more about our service.