Understand Why A Trading Strategy Works

Whatever The Input To Your Trading Strategy

There is a very simple fundamental truth to any trading strategy out there. Whether you are a discretionary trader, a fundamental trader, a quant, a mechanical technical trader, or maybe you simply trade your gut feel or let your monkey throw darts. Whatever it is, your strategy is somewhere on the following graph.

The Reward-Risk-Ratio vs. Win Percentage Continuum

The Two Parameters For Any Trading Strategy

Two parameters determine the profitability of your strategy: the win percentage in combination with your reward-to-risk ratio (RRR). The win percentage is the average number of profitable trades out of 100. The RRR is the average size of each winner compared to its initial risk. Say you have a very simple strategy where each of your trades has a predetermined entry, stop loss and profit target price. And your potential profit on each trade is exactly the same amount of pips as your potential loss, so your RRR is 1. What follows is, that you will break even as a trader if you win percentage is 50%. The classical coin flip.

So Which Trading Strategies Work?

In the above chart you will be on the dark blue line with a strategy resembling the classical coin flip of 50% winners and 1:1 RRR.  The dark blue line describes all combinations of win percentage and RRR that break even. Any strategy with a combination of win percentage and RRR which puts you below the dark blue line (in the lighter blue area) and you are losing money. So you absolutely must have a tuple of win percentage and RRR that puts you above the blue line, safely in the promised land of profitability. The further you can move away from the blue area the closer you are to the “holy grail” of trading. It’s that simple!