When it comes to cooking, there is more than one recipe for making a delicious spaghetti sauce. When it comes to trading, the same is true – there is more than one way to design a successful trading strategy. At one time or another, every trader or investor has been taught that the smart thing to do is to maintain a 2:1 risk-reward ratio or better. This means that for every $100 risked on a trade, the return should be at least $200. For some traders, this type of money management will work, but for others who have seen at least one of their profitable trades reverse violently and eventually be stopped out, this type of risk-reward ratio is idealistic and not realistic. In fact, trying to maintain a 2:1 risk-reward ratio could be keeping a lot of unprofitable traders from turning profitable. Not many people realise that 1:1 risk-reward ratios can still yield positive results in the FX market as long as you have a high probability trading strategy.
High Probability versus High Profit
In order for a 1:1 risk reward ratio to work, you would need to have a high probability trading strategy that is successful at least 65 to 70% of the time. This is not impossible especially if you are an ultra short term trader that is only looking to make a small amount of pips. However, in order for it to be net positive, more than half of your trades would need to be winners. For example, if you plan to risk 20 pips on every currency trade, with a return of only 20 pips, 50% of your trades would need to hit their profit targets in order for you to breakeven. Sixty percent of the trades would need to hit their profit targets for you to make 40 pips. If 70% of the trades were winners, then you would be up 80 pips on every 10 trades.
Here is an example of a high probability trading strategy that is loosely based off of the ‘Momentum Strategy’ in the second edition of my new book Day Trading the Currency Market. In this strategy, we are simply looking for the price to break the 20 Simple Moving Average on a closing basis and for the MACD to confirm the direction of the trade within the past five bars (the strategy uses five minute charts).
More specifically if the currency pair closes above the moving average and MACD has crossed from negative to positive within the last five bars, then we go long the currency pair. If price closes below the moving average and MACD has crossed from positive to negative within the last five bars, then we short the currency pair. Thirty pips are risked on each trade for a return of 30 pips.
As you can see in the following example of the GBP/USD four out of the five trades were profitable for a net return of 90 pips and an accuracy rate of 80%.
List of Trades
Trade #1 – LONG GBP/USD Entry at 1.4914, take profit at 1.4944 +30 pips
Trade #2 – SHORT GBP/USD Entry at 1.4925, take profit at 1.4895 +30 pips
Trade #3 – LONG GBP/USD Entry at 1.4930, take profit at 1.4960 +30 pips
Trade #4 – SHORT GBP/USD Entry at 1.4915, take profit at 1.4885 +30 pips
Trade #5 – LONG GBP/USD Entry at 1.4905, stopped at 1.4975 -30 pips
With a high-profit trading strategy however, the success rate can be far lower as long as the risk reward ratio is high. If you had a trading strategy that risked 50 pips for a return of 150 pips on every currency trade, you would only need to be successful 30% of the time to be net positive. In other words, if seven out of 10 trades were losers and three were winners, the net return would still be 100 pips.
A moving average crossover strategy is typically a high profit but low probability trading strategy. The following chart is an example of a strategy that is based upon a 10 and 20-simple moving average (SMA) crossover. In this strategy, we go long the currency pair when the 10-hour SMA crosses above the 20-hour SMA. The trade remains open until the currency pair breaks the 20-SMA. For a short trade, the guidelines are reversed. The currency pair is sold when the 10-hour SMA crosses below the 20-hour SMA; the exit rule remains the same. As you can see in the following example in the AUD/USD four out of the five trades were unprofitable for an accuracy rate of only 20%, but the net return was still 25 pips.
List of Trades
Trade #1 – SHORT AUD/USD Entry at 0.6465, exit at 0.6485 -20 pips
Trade #2 – LONG AUD/USD Entry at 0.6530, exit at 0.6470 -60 pips
Trade #3 – SHORT AUD/USD Entry at 0.6470, exit at 0.6495 -25 pips
Trade #4 – LONG AUD/USD Entry at 0.6520, exit at 0.6470 -50 pips
Trade #5 – SHORT AUD/USD Entry at 0.6380, exit at 0.6200 +180 pips
The difference between a high probability and a high profit trading strategy is that one focuses on small consistent wins while the other swings for the fences. Both can yield positive results in their own right, but swinging for the fences is the most common way to trade and may also be the reason why many novice traders have a tough time staying alive in the currency market. With a high profit trade which is characteristic of picking tops and bottoms, one may need to be able to survive a lot of misses before the big winner is hit. Unsurprisingly, high probability trading is usually synonymous with shorter trade trading while high profit trading usually applies to longer term trades.
Of course everyone hopes to find a trading strategy that is both high probability and high profit but doing so may be as difficult as finding the Holy Grail.
Two Lot Method
One way to increase the probability of winning trades is to follow the two lot method that I use in my forex signal service, BKTraderFX. In 2008, 80 out of the 103 trades were winners, for an accuracy rate of approximately 78%. With each trade, there is always a short target and a long target which means that I trade in multiples of two. The first target is usually easily achievable while the long target is two to three times risk. I always trail the stop as the trade progresses to lock in profits along the way because my trading motto is to never let a winner turn into a loser. The trades are always based on a combination of fundamental and technical analysis.
By trading more than two lots, you expose yourself to double the risk because if your stop is 50 pips away from your entry for example and you are stopped out on two lots, the real loss is 100 pips. This is why it is absolutely necessary to make sure that you are confident in your high probability trading strategy. If you are relatively certain that you can make 10 pips a day for example, then stick with that target and just adjust your trading size.
Two Different Traders, One Result
The type of trading strategy that you have is just as important as trade management. In the currency market, technical analysis is probably, hands down, the most popular way to analyse currencies. Both new and seasoned traders will spend the majority of their time looking at chart patterns, drawing Fibonacci levels, counting Elliott Waves or creating their own combination of indicators with the ultimate goal of developing a trading strategy that gives the perfect entry signal. Based upon my experience however the exit is just as important as the entry. A few years ago, I remember talking to Rob Booker, a fellow currency trader about the importance of entries and exits and he said to me that asking him this question is like asking a pilot what is more important – the take-off or the landing? I am sure that almost anyone who has been on a plane will agree that BOTH are important. This is why every single one of my trading strategies uses the two lot method.
While working at JPMorgan Chase, I once traded alongside two extremely talented FX traders. They went long and short the EUR/USD at the same time and interestingly enough both ended up making money. The trader who went long Euros traded off five minute charts and held his position for no more than 20 minutes while the trader who went short Euros traded off one hour charts and held his position for four hours. The reason why both traders were able to make money even though they had conflicting positions is because of trade management. I strongly believe that the management of the trade is critical to successful trading regardless of whether you practise high probability or high profit trading. How many times have you kicked yourself wishing that you had locked in profits or moved your stop?
As in cooking there is always more than one recipe for trading success and if you are frustrated with trying to adhere to a 2:1 risk reward ratio, high probability trading may be right for you.