So you have obeyed the gurus, who told you that in order to be profitable, you must have your target at 3 times the distance to your stop; and that that should pretty much ensure your success. You have done it, but you equity is still going down. Now you want to know what is wrong.
Well, for starters, how often is your target hit as opposed to your stop? Do you even have records to be able to answer that question? Here is a question for you: “If your target is seldom hit, why would you expect that you would make any money?” After all, you make money when you exit, so if you almost never exit at the target, what else would you expect? After the first series of posts, a reader emailed to castigate me for saying that stops may be reached first 80% of the time if one is using a so-called 3:1 reward/risk ratio. He says that that number should be more like 95%. Regardless the percentage, we would still do the exact, same analysis, to find out whether we even have a winning method. In what follows, we shall continue to use our 80% hitting the stop first, and 20% hitting the target first, with a 3:1 reward to risk ratio; a 30 tick target and a 10 tick stop, that we used for the discussion in Parts 1a, 1b and 1c.
So now let us see where the money is going. As always: “Follow the money!”
First let us look at what happens when we are hitting the stop first. To make things simpler, let us, again, look at the same 100 instances that we examined in Part1 of this series.
- We hit the stop first on 80 occasions, each time losing 10 ticks.
- So the total ticks lost would be 80 x 10 = 800 ticks. (80 losing instances multiplied by 10 ticks in each instance).
Now we look at when we hit the target first.
- We hit the target first on 20 occasions, each time profiting 30 ticks.
- So the total ticks profited would be 20 x 30 = 600 ticks. (20 profiting instances multiplied by 30 ticks on each instance.
Clearly then in these 100 instances that we measured, we made a loss of 200 ticks (600 ticks profited – 800 ticks lost).
But, you say: “My target ticks was 3 times my stop ticks. The gurus say that is all that I need to do to be profitable. So why am I losing?” The answer lies in the assumptions that were made, and that nobody told you about. There is no magic ratio. What returns a trading method makes is not dependent only on some magic ratio of 3:1 or 2:1 or any other ratio. Profitability depends on both the size of the targets/stops and the probability of reaching them. After all, taking this to the extreme, what is the point in having a large target if you will never reach it to take a profit? For that matter what is the point of having a very small stop if it is continually being hit before the trade can take off? Do you really love “death by a thousand cuts”?
In the next write-up in this series, we shall take a deeper look at the price and distance relationships, and how they affect profitability.
In the meantime, if you found this useful, please leave a comment.