It usually pays off best for new traders to focus on making a few big winning trades and not worrying too much about lots of losers, provided the wins are big enough. This is how the market works (markets are “fat-tailed”) and it the easiest money-making method technically, if not psychologically. This can be frustrating to deal with, though, as it requires a great deal of persistence to get through the long losing streaks, and to sit tight while watching small winners turn bad and become losing trades. Is there another way? One of the classic “holy grails” of trading is to make money by having a very high win rate and using that high probability to harness the power of compounding.
To try to illustrate the contrast between these two approaches, let’s imagine two different trading strategies that, theoretically at least, produce the same positive expectancy, i.e. average profit per trade, but with very different win rates and reward to risk ratios. Trading strategy A uses a profit target of 2:1 and has a win rate of 40%. This gives it a positive expectancy of 20% profit per trade ((40% X 2) – 60%)). Trading strategy B uses a profit target of 1:1 and has a win rate of 60%. This also has the same positive expectancy of 20% per trade ((60% X 1) – 40%).
If you think these two strategies would therefore be just as attractive to trade from the consideration of profitability alone, think again: using the Kelly Criteria as a scientific estimation of the optimal risk allocation per trade, strategy A gets 10%, while strategy B gets 20%. Over a long time, probability suggests you would make twice as much profit trading strategy B with the higher win rate. This is due to compounding.
So why do most trading experts instinctively prefer a strategy with a lower win rate than a higher reward? Simply put, it is because strategies with high win rates are fragile and very questionable. It is almost impossible, probably even completely impossible, to write any trading formula that will secure a win rate at a minimum reward of 1:1 greater than approximately 55%, if it is tested over a lengthy period (several years) and thousands of trades. Discretionary traders, though, often claim an ability to cherry-pick the very best trades and secure win rates at 1:1 of as much as 70%. That is a figure that is often quoted and, interestingly, it is a number cited by the legendary trader Jesse Livermore as the maximum reliability of any kind of technical analysis, over one hundred years ago.
A final word of warning: beware of breaking your neck on the rocks below if you embark on the very perilous path of looking to secure a high win rate, say above 55% or thereabouts. It is much, much safer to try to hit home runs and accept lots of small losses, provided you trade small.