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How to Be a Trader (Part 2): Risk/Reward
01/21/2016 6:00 am EST
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.
In contrast, there are trend-fading strategies, which work best in sideways markets. The idea is to sell at resistance, hoping that prices will retrace and you can buy back lower.
As an example, in sideways markets, many traders like to sell at the upper Bollinger band and buy at the lower Bollinger band.
When using these kinds of strategies, you typically have a reward/risk ratio of 1 to 1, i.e., you are risking $100 trying to make $100. Therefore, you need a winning percentage greater than 50% in order to be profitable. Often, trend-fading strategies have winning percentages between 55% and 75%.
Then there are scalping strategies. When using a scalping strategy, you apply a rather large stop loss and use a small profit target. It is not unusual for a scalping strategy to have a reward/risk ratio of only 0.5 to 1 or even less, i.e., you are risking $100 to make $50. Obviously, you need a high winning percentage for this strategy to work. That's why often, scalping strategies have winning percentages of 80% and more.
Here's an extreme example of a scalping strategy:
Buy the e-mini Dow tomorrow morning at the open and do not set a stop loss. Use a profit target of ten points.
This trading strategy has a winning percentage of 99.9%, because how likely is it that the Dow Jones moves to zero? Next to nothing, right?
So often you will hit your profit target. The problem is time. It might take days, weeks, months, or maybe even years before your profit target is hit. But if you could sustain the drawdown while being in the trade, you would have an extremely high winning percentage.
Obviously, this is just an example. Don't even think about doing it! Still, I'm sure you understand what I'm trying to explain here.
Why You Must Be Able to Determine Market Direction
So why is it so important to learn to identify the direction of the market? Because the direction of the market determines what kind of strategy you need to use!
- In a trending market, you use a trend-following strategy
- In a sideways market, you use a trend-fading strategy
If you use a trend-following strategy in a sideways market, you will get whipsawed, and if you use a trend-fading strategy is a trending market, you will get stopped out frequently.
Have you every experienced the following: You trade a strategy, and sometimes the strategy works great, but then there are other times when the strategy underperforms. If this has ever happened to you, then you probably traded the wrong strategy for the market conditions at the time.
That's why I like to use multiple trading strategies. I use trend-following strategies in trending markets and trend-fading strategies in sideways markets. (I explained the strategies I use in this previous article.)
The most important skill of a trader is to determine the direction of the market since the market condition determines what trading strategy you should use.
To date, I haven't seen a strategy that performs equally well in trending and sideways markets. Your strategy is either a trend-following strategy that performs well in trending markets, or it is a trend-fading strategy that performs well in sideways markets.
If you apply the wrong strategy, you will be swimming against the stream. Or, as Hubert Senters likes to say, "It's like hitting yourself with a hammer on the head. It feels good when you stop doing it."
Tomorrow, in Part 3, I will show you some simple tricks for how you can easily identify the direction of the market.
By Markus Heitkoetter, founder and CEO, Rockwell Trading