Last week we stated that by itself, claims of a “Highly Accurate Trading System” were completely and totally meaningless. As we stated then, we are going to attempt to make a point that we made in in our “Money Management” series. But allow me to re-iterate the concept here as it’s something we see again and again and again with new traders.
Somewhere along the way, new traders run into the concept of a ‘risk reward ratio’. In other words, the concept of risking $1.00 with the goal of making $3.00. This is a very important concept, and one that is vital to understand in order to trade well. We do not mean to minimize this concept.
But as with ‘Accuracy’ or ‘Hit Rates’, you cannot view a ‘risk / reward ratio’ as a ‘stand-alone’ metric. And please understand the inverse relationship between accuracy rates, and the risk / reward ratio.
What do we mean?
Well, usually new folks develop a thought process then goes along the idea of: “Well … great! Let me find a short-term trading methodology that is 85% accurate, with outcomes that produce 1 risk, to 3 reward!“
When you find such a process with such results, I am going to ask you a simple favor …
Could you please let us know about it?
Because to date no process like that has been found to exist.
As a matter of fact if you’d like a short-hand way of determining whether or not someone is lying through their teeth to you about their trading performance? When someone begins to tell you that their swing-trading process is 80% accurate, with a 1 risk to 4 reward ratio with any amount of longevity.
It doesn’t work that way folks.
Risk / reward, and accuracy … or ‘hit rates’ are inversely related over a long period of time. So you can either highly accurate process, with a lower risk / reward ratio; or you can accept a lower accuracy rate, with a higher risk reward ratio.
This is one area in which you cannot have your cake, and eat it too.
And do not be lured to believe other-wise by brief time periods, that may seem to indicate the opposite is true.
What do I mean?
I had a time period, that I was running like … 78% accurate, with a 1 risk to 2.6 reward.
That’s supposed to be impossible.
And let me tell you …
For long time periods? It is impossible. Do not be lured to believe otherwise by what I would refer to as “contextually favorable trading environments”.
For example, in 2010? I was running the above stats. There was a time that I was about 78% accurate. With a ratio of about 1 risk, to 2.6 reward. Why? Because I was such an awesome trader?
No. Not at all.
I had just so happened by sheer dumb luck to run into a market that offered a ridiculous amount of low-hanging fruit. I was firmly in the camp, that Sugar #11 Futures would rally, and rally hard for an extended period of time. So I kept taking trade after trade after trade, of going long Sugar Futures. I’d hold it for 3 days. Then wait for the smallest of dips. Then go long again. Then wait a day or two, wait for a dip, buy Sugar #11 Futures again, and hold for a few days.
For a brief moment in time simply because of the context of one market that I just happened to have the dumb stupid luck to run into, I was very, very accurate, for that brief time period, and had a ridiculous risk reward ratio.
But it cannot last.
And let me tell you from intimate experience, those time periods can also actually be very dangerous. It lulls you into the belief that since you’ve done it once, than you just have to find that easy market again where you can pull high hit rates, with great R/R’s.
The problem being of course, is that you can’t predict the future. It’s impossible to predict when such low-hanging fruit will appear. So in trying to force, what SEEMED very easy to do … you can end up causing a LOT of damage to a trading account.
Over any length of time, it’s a case of either one, or the other. Hit rates, and R/R ratios, are one of those things, that you just have to decide what you are comfortable with, and go with that. You really cannot have your cake and eat it too. If you run into a time period where it seems to be otherwise? It’s just a chance happenstance. Enjoy the peace and power of it, while it lasts. Do not be lured in by it. Because it literally cannot last for long.