Basics Of Risk Management

When it comes to risk management, the potential for improvement is still high because many traders neglect the importance of risk management or do not know where to start. This is good news because, with a few small tweaks and a better understanding of how risk management works, traders can potentially get a much better grasp of their trading and their performance.

The winrate

“How can I get a better winrate?” is probably among the most commonly asked questions I get every day. I get it, a higher winrate sounds nice because you’d have fewer losing trades, less negative feedback and more winners. But will this automatically make you a better trader? No!

The winrate is an important metric, but it is not meaningful on its own. Assume that a trader has a winrate of 90%, but his losses are always 10 times larger than his winners. This is not uncommon when amateur traders cut their winners way too early and let their losses get out of hand. Furthermore, when you have an extremely high winrate, you are probably not good at dealing with losing trades because they happen so infrequently. Thus, when a loss comes around, traders easily panic, try to “avoid” it and then trade emotionally and make all the costly mistakes.

Did you know that trading systems with a winrate of 50%, 40% or lower can also make you money potentially? It is true and the graph below shows the relationship between winrate and the reward:risk ratio. For example, when your winners are twice as large as your average loss (a 2:1 reward/risk ratio), then you’d only need a winrate of 33% or higher.

Traders cannot directly control their winrate and you cannot just choose to have a higher winrate. This brings us to the next metric: the reward/risk ratio.

Reward:Risk Ratio

The reward:risk ratio is, as the name suggests, the ratio between the potential profit and the potential loss of a single trade. To determine the reward:risk ratio, a trader takes the distance between the entry and the stop loss (potential risk) and compares it to the distance between the entry and the take profit target (potential reward).

As we have seen, the reward:risk ratio and the winrate are closely linked. The good news is, the reward:risk ratio can be controlled more directly than the winrate.

A larger reward:risk ratio

A trader could choose to use a tighter stop loss or a wider target to increase his reward:risk ratio. This would also mean that he’d need a lower winrate to trade profitably potentially. However, what then will happen is that the price will more easily reach his stop loss and it has also a harder time reaching his target. Thus, tightening a stop and widening targets will lead to an overall lower winrate. This is not necessarily bad because even with a lower winrate, you can still make money when your reward:risk ratio isn’t too small.

With a reward:risk ratio of 3:1, for example, the trader only needs a winrate of higher than 25%. That sounds realistic, right!?

A lower reward:risk ratio

On the other hand, one could choose to use a wider stop loss and a tighter target. This would mean that the reward:risk ratio decreases. The price now has an easier time reaching the target and the trade would have more “room for error” because the need for accuracy is decreased with a wider stop loss. This could lead to an increase of the overall winrate too.

You see, even though the idea of a smaller reward:risk ratio doesn’t sound too appealing at first glance, it is not necessarily bad.

Holding time

The holding time is directly linked to the reward:risk ratio because the wider the target, the longer it will take the price to make its way to the target. And if you have some trading experience, you will probably know that staying in winning trades is not that easy. Cutting winners too early is a common issue because traders constantly fear that the price could turn around and wipe out all their unrealized profits.

Thus, just choosing a wider target might sound like a good idea at first, but it comes with a host of issues. If you know that you struggle with letting winners run, you need to make those target-adjustment decisions very carefully and observe how you respond emotionally.

Emotional stability

I briefly touched on this already and as we all know, emotions and trading psychology are a big part of trading. Winrate, the reward:risk ratio and the holding time are major factors when it comes to emotional issues.

The winrate determines how much positive and negative feedback you’ll get from your trading strategy. A high winrate system can be beneficial but if your system has a very large winrate, a single loss can easily throw you off when you are not used to dealing with loses.

At the same time, high winrate systems usually have a low reward:risk ratio which can also be problematic because it means that your winners and your losses have roughly the same size. Thus, it will take much longer to get out of a losing streak and recovering from losses takes time.

A low winrate system with a high reward:risk ratio is usually how the professionals trade. The professionals can stay in winning trades without emotional problems and, therefore, make full use of the benefits of a high reward:risk ratio system. When one winning trade pays for your past 4,5 or even 7 losses, the role of losses changes completely. A loss is then not that threatening anymore because you know that it only takes one good trade to make up for them.

Danger: High winrate, high reward:risk ratio

Although it sounds great on paper and most amateurs wish that they could have such a system, it is almost impossible to achieve (we have seen how reward:risk ratio and winrate negatively correlate). Furthermore, it is not even necessary either.

You can, at least on paper, make a lot of money trading a 50% winrate and a 2:1 reward:risk ratio. There is no need to go all out and try to catch huge winning trades while, at the same time, stressing about achieving a higher winrate.

Many failed traders are chasing such trading systems and then end up never making it, whereas they could have become a profitable trader much easier if they’d just taken what is realistic and attainable.

Thus, avoid trying to increase your winrate and focus on how everything is linked. Then, you can make better decisions and create a trading strategy that fits your personality.