What a trader needs to know to improve profitability

What am I working on the most to improve my trading profitability? 

A question, some would think, answered with reference to strategy or method, but it is not that, as significant as it is.

It is regardless of a traders methodology.

What makes a massive difference to profitability is knowing these three inputs: R, win/loss percentage and per cent of account balance risked per trade.

Professional poker players calculate ‘risk of ruin’ (ROR) as a measure of probability, and it applies equally to financial trading.

To calculate our ROR, we need all three inputs, and the smallest of tweaks can make a significant difference.

It applies equally to financial trading.

The measurement of R 

What is R? This refers to reward/risk.

When entering a trade, a professional trader will immediately place a stop loss position coincidental with the trade position.

In the above instance, if our stop is activated, that would be recorded as a -1R trade. (As long as each entry has the same risk amount). If, however, our deal is profitable and we exit at a regular price equal to our stop price position, then we achieve a +1R. On the other hand, if we deliver twice the target distance as compared to the stop position than we would record a +2R, and so on.

Knowledge of the R achieved is essential as a measure towards determining ROR. 

Win/loss percentage.

Win/loss shown as a difference in wins compared to losses shown as a percentage. 

In ‘Market Wizards’ (where Jack Schwager interviews top traders) Schwager gives the ‘wizards’ two choices. A strategy with a high win/loss ratio and a low R, or a small win/loss strategy with a high R. 

I forget the exact wording as it’s a while since I read the book; however, I do recall that all ‘wizards’ took the latter and without hesitation. Most retail traders would probably plump for the former. (If nothing else this indicates the power of R).

Win/loss is better if expressed as a percentage of each strategy traded to provide a complete understanding of the underlying ROR.

How many trades are needed to give a measurable win/loss? There is no exact answer, but my guess would be at least 100 and somewhere between 500 and 1000 measured trades would be better. Of course, these can be a demo or simulated trades; however, ‘live’ trades are always going to be a truer confirmation of a traders skill level. 

Account balance risked per trade.

Getting account balance percentage wrong is probably why most traders burn their accounts at some point (often early) in their trading careers. I was no different. 

In almost all books or trading courses, the explanation of ‘per cent of account balance risked per trade’ is weak. Thus leaving it open to individuals own interpretation resulting not infrequently to a ruinous outcome.

Yes, trading courses point out the need to trade as a percentage of the account. Maybe one or two per cent is provided as a loose example. In reality, it is much more exact than this.

Without having each of these measures of R, win/loss and per cent of account balance risked per trade, it is not possible to calculate the all-important ROR.

Only when we have all three accurately available can we know what we need to tweak to improve our profitability.  

Return relative to risk

Below we have our previous 30 days of trading results.

They look similar to the last report regarding gain and percentage win. But in reality, are very different.

Such summaries provide useful figures but often not the important ones. It is nice to know the overall gain. After all, that is our purpose. However, I would like to know how we achieved that gain, or more accurately ‘what was our return relative to risk’?

The amount of leverage we can use is about to change significantly with the European regulation on margin to be introduced at the end of next week.

I have tended to trade on margin rather than on a firm stop. That is, if a trade went against me I would often hold and look for a suitable scale-in point to provide a break-even opportunity or, quite often, a profit.

All well and good until we are caught out with a massive move against us. That happened to us this period on not one but three currency pairings simultaneously.

Our return relative to risk was poor this period. And that has to change. Not only are such trades overly difficult to manage they are likely to create an excessive loss. In any case, the new regulation and change in margin will make such a strategy untenable.

Setting hard stops that provide a planned reward to risk of not less than one to one will offer more (albeit smaller and controlled) losses but also free us early to reenter with a new trade; rather than sometimes being locked into a scaled-in extended detrimental equity trade.

Stats for the last 30 days of trading.
The stats often don’t tell the whole story.

Reward/risk has to be right

Slightly embarrassingly on my part, I discovered something simple but fundamentally wrong with my trading. I adjusted today and amended my ‘how to trade’ page. Even a tweak, if it is a significant tweak, can make a profound difference.

As in many things, but I feel particularly in trading, I cannot be so keen on my backtest work that I’m not prepared to take a fresh look once I’m in the trading room for real. As Yogi Berra said, “in theory, there is no difference between theory and practise; in practice there is.”

My foundation is my reward/risk, or what is referred to as R. To achieve a planned 2R (actual R can be much better) means that my planned reward is twice my planned risk. I had the minimum acceptable R as too small. Again, in theory (or backtest) it’s okay but in practice – often with a less precise entry point and a variable spread – working with less than 1R is not viable for me.

I call a 1R a scalp and a 2R a swing. My strategy, because of my abundance of less than 1R scalp opportunities, was scalp/swing. And this provided me with few swings. Moreover, the scalp element (less than 1R) required an 80% (win/loss) success rate to see an accumulation of reward.

Changing to swing/scalp and limiting scalp to not less than 1R is much preferable. Profitable scalp percentage is now 60% – still high but that’s the issue with scalping. And the swing percentage to be useful is 40%; anyone suggesting less does not have a spread to contend with (prop trader rather than retail trader), or they’ve ignored it.

To a non-trader, this all seems a lot about nothing. But it’s like a golfer playing a match without the long clubs and therefore having to take too many hits on the par five holes.