4 min read
The VWAP Indicator in Trading: A Comprehensive Guide
Among the many available indicators, the VWAP indicator—or Volume Weighted Average Price—is particularly popular for day trading. By analyzing price...
No, the title isn’t a typo and we are not completely bananas either. The concept we are about to share with you will provide a completely different view to what common trading knowledge teaches. But how often do people actually make money by following general trading wisdom?
You always hear traders talk about avoiding mediocre setups and only picking the best setups possible. But how true are these statements and what makes a setup a good one? We’ll show you what most traders get wrong and how you can improve your trading performance by being aware of a few simple statistical concepts and applying common sense to trading. We can tell you that much already: do not avoid mediocre setups because you will lose money.
Premium and A+ are the terms that get thrown around by traders when talking about the quality of trade setups. But did you know that traders are completely wrong when they stop taking mediocre setups? You’ll lose a lot of money if you only take the best setups. Before you now start taking random trades, do yourself a favor and read on.
If we talk about high quality setups we actually mean setups with a high winrate. To illustrate the whole concept we’ll introduce the following example. Let’s say you are a price action trader and you trade support and resistance. You might have a trade-checklist with 6 filter criteria for your entries:
(These signals DO NOT describe an actual trading strategy. We made the entry-criteria up to illustrate the concept.)
If you have a decent trading journal (go and get one!) and collected data on a big enough sample size, your statistics might show you that a setup with all 6 entry-criteria has a winrate of 60%. But obviously, seeing all 6 things happen simultaneously at the same time is pretty rare and you don’t get a trading signal very often.
What about a setup where you only require 4 out of the 6? These trading opportunities will present themselves more often. However, the fewer entry-criteria, the lower the winrate usually is – unless you use irrelevant entry-criteria that do not contribute to enhancing the odds of taking a successful trade.
The quality of a setup is determined by its likelihood of turning into a winning trade. A winrate alone doesn’t tell you much though. You always have to set it in relation to the risk:reward ratio. A setup with a winrate of 60% can make you lose money consistently, whereas a setup with a winrate of 30% can mean financial freedom. It all depends on the combination of risk:reward and winrate.
In a nutshell, trades with a lower winrate require a higher risk:reward ratio (or vice versa). But if you just place your take profit orders a little further away to make up for a lower winrate, you are in trouble. Widening take profit orders can have a significant effect on the outcome of your trades. Therefore, you should test, collect data and analyze the effects of a lower winrate together with a higher risk:reward.
A lower winrate means that you will lose more often – that’s a no-brainer. But it further implies that the volatility on your account balance will be much higher. You cannot follow!? You will get more trading signals if you take trades with fewer entry-criteria and these trades will have a lower winrate. Therefore, you will realize more losing trades and the likelihood of having longer losing streaks is higher as well. All these factors combined will result in bigger swings on your account balance.
In an ideal world, a winrate of 60% and a reward:risk ratio of 2:1 could look something like this: a steady and exponentially growing equity curve – a trader’s dream of becoming rich quick.
The fact that realizing such a steady growth is not as simple as combining some mathematical figures and plotting it into a program is a different story though and we will keep it for later.
The good news is that, as long as the risk:reward ratio and the winrate work together, you won’t lose money. In the first step, we decreased the winrate to 50%, keeping the other parameters constant.
As you can see, the curve is still pointing upwards. But it’s also clear that the swings on the account balance are getting bigger.
If your winrate drops, the likelihood of having losing streaks increases and therefore the likelihood of bigger drawdowns as well.
Our winrate is now 40%, and although the curve is still pointing upwards nicely, the volatility of your account balance is becoming significant.
In an ideal, mathematical world, this won’t be a problem because statistics work in our favor and the combination of a 40% winrate and a 2:1 reward:risk ratio will make you money – no matter what. But since we are only humans and pretty bad when it comes to dealing with statistics, this ideal curve is very hard to achieve. After having 5 losing trades in a row, most traders will start doubting their trading strategy, and facing a drawdown of several hundred Dollars can be very challenging too. Therefore, traders tend to mess around with their trading strategy, change rules, try to make up for losses by gambling and go on tilt.
The first change you should make when trading setups with a lower winrate is requiring a higher risk:reward ratio.
Although, in our example, the minimal required reward:risk ratio with a 40% winrate is 1.5, an actual ratio close to 1.5 will result in a high account volatility and a slow, unsteady growth.
Therefore, we increase the reward:risk to 3:1, and as you can see, the growth of the equity-curve is much more linear. Nevertheless, the volatility on the account balance is still quite significant. Therefore, we need to make further adjustments.
The next step to achieve a steadier and smooth account growth is to lower the risk per trade. Although this results in a slower account growth, you can eliminate the significance of drawdowns and therefore, realize a much smoother equity growth. This will also take away a lot of psychological pressure and makes it easier to cope with losing streaks.
Throughout the article we talked about risking more on high-quality setups and decreasing your risk when trading setups with a lower winrate. While this sounds all good in theory, there are two things to consider before implementing this approach.
You will leave a lot of money on the table by not taking mediocre setups. But before you start taking trades that don’t match all your entry criteria, it’s mandatory to do your homework and test different kinds of setups, crunch numbers and analyze the outcome when you change the parameters of your trading strategy.
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