Markus Heitkoetter discusses reward/risk ratios and winning percentage, and why determining the direction of the market is any trader's most valuable skill.
In Part 1 of this three-part article series, "How to Be a Trader," we talked about the mindset of a trader and the importance of having realistic goals. You have learned that consistency is more important than windfall profits every now and then, and that a weekly target of only $100-$200 can compound to very nice yearly returns.
Today, we will talk about the most important skill of a trader, whether daytrading or swing trading. It doesn't matter whether you are trading stocks, forex, options, or futures, and it doesn't matter whether you are new to trading or have been trading for a while. The skill I am going to talk about in this article is the foundation that every trader needs. If you cannot master it, your chances of making money trading are slim to none.
So here is the most important skill of a trader:
Step 2: Determine the Direction of the Market
You must be able to read a chart and determine whether the market is going up, down, or sideways.
Trading is not that complicated. If the market is going up, you buy, and if the market is going down, you sell. If the market is going sideways, you either stay out and wait until it is trending again, or you apply a more advanced trend-fading strategy.
In the previous article, we talked about finding a trading strategy with a positive reward/risk ratio. We used the example of a reward/risk ratio of 1.5 to 1, i.e., you risk $100 to make $150.
Understanding Reward/Risk Ratio and Winning Percentage
You need to understand that there's a strong correlation between the winning percentage and the reward/risk ratio. The higher the reward/risk ratio, the lower the winning percentage.
Here's an example:
You might have heard about so-called "home-run strategies." When using such a strategy, you use a small stop loss and quite a large profit target. Often, these strategies have a reward/risk ratio of 5 to 1, i.e., you risk $100 to make $500.
If you choose to trade such a strategy, it is not unusual to have a winning percentage of only 25%-35%. Still, you would still be profitable since you will make much more money on your winning trades than you lose on your losing trades. In fact, only one winning trade would make back all the money you lost on five losing trades, so as long as your winning percentage stays above 20%, you're good.
When trading such a strategy, you obviously need a trending market. You want to make sure that prices are moving in your favor for a long time. That's why these kind of trading strategies are called trend-following strategies.
Trend-following strategies typically have a reward/risk ratio above 1.