2.11. Risk – reward – probability

Let’s talk about risk-reward. Most of Forex Trading gurus will tell you:

  • To risk 1-2% of your capital per trade and,
  • The risk reward ratio should be at least 1:1 or 1:2. More reward is better.

OK, let’s analyze it:

  • To risk 1-2% of your capital per trade.

You should ask how much the capital is. If your capital is USD 1000 and you trade 1 standard lot then you are already doomed from the beginning.

Let’s do some math:

If you risk 1% of your capital, it means your stop loss will be also 1% of your capital.

Assume that you trade USD cross pair, then 1 pips equal USD 10.

If you trade 1 standard lot, then it means your stop loss will be 1 pip.

How can you survive then? If you say that this example is a bit too extreme; it is true; but sadly, it is real. A friend of mine swiped his credit card for USD 100 and traded a standard lot, the money was gone in minutes. And he swiped for 5 more times then he quitted; he lost USD 500 within hours.

If you have 1,000 USD balance and trade 1 mini lot and your risk 2% of your capital per trade; it means your risk is 20 USD or your stop loss is 20 pips. If you lose, the next trade you will have less than 20 pips stop loss, which is 19.6 pips; and your stop loss will become less and less for the subsequent loss. And the result is that your stop loss will be taken easier and easier! It does not make sense at all if you use this kind of risk management.

 

 

  • The risk reward ratio should be at least 1:1 or 1:2. More reward is better.

If you have risk reward ratio (in pips) of 25:25, 25:50, 50:50, 50:100, then your Stop Loss will be hit frequently before reaching your target because of Average True Range (ATR) most of currency pairs are above 100 pips per day. It used to be average 300 pips ATR / day for GBP/JPY, average 200 pips for EUR/JPY, around 100 pips ATR for most other pairs and less than 100 pips for EUR/GBP. Every pair has its own character; it has its own ATR; it tends to move a lot in certain market time; etc.

 

The probability of your Stop Loss being hit before reaching target profit is very high if Stop Loss < ATR and Target Profit > ATR. If your stop loss is being hit more often than your target profit, your risk reward ratio will change. If you have a risk reward ratio of 1:1 before, in reality it may become 2:1 or 3:1 or even worse; if you have a risk reward ratio of 1:2, it may become 1:1 or 2:1. And before you realize it, you have lost substantial capital without knowing why. It is because you do not put “probability” in your equation.

For example: you have a risk-reward ratio of 1:2, 25 pips Stop Loss and 50 pips target profit. In reality, on average your stop loss will be hit two times more often before your target profit is hit. Therefore, your risk reward will be 1:1 instead of 1:2.

 

Some traders put their Stop Loss > ATR to make the probability of their Stop Loss being hit lower. By making your Stop Loss bigger, you will need to make your Target Profit bigger also to maintain the risk-reward ratio of at least 1:1. High Target Profit is more difficult to achieve; market tend to reverse, swing up and down before reaching its target. Therefore by making your Stop Loss more difficult to be taken, you also make the probability of your Target Profit being hit lower.

 

 

There are two kinds of probabilities:

  • Probability of where the price is going to be. Which is 50:50, 50% up and 50% down.
  • Probability of your target profit or stop loss being hit. The probability is:
    • The smaller your target profit or stop loss is the higher the probability of your target profit or stop loss will be hit.
    • The bigger your target profit or stop loss is the smaller the probability of your target profit or stop loss will be hit.

 

I have not seen a single Forex Trading book or articles so far that put Probability as part of the Risk – Reward analysis. Probability is the same important variable as Risk and Reward. Three of them will make a complete analysis, not Risk and Reward only. Most traders do not put Probability analysis; that is why they miss the big picture and that is why their Stop Loss got hit frequently.

 

So, the one million question is what is my risk reward should be.

The answer is to:

put your trade risk free and you will have unlimited reward

 

You make your trade risk free is by using no leverage or proper leverage. By using no leverage or proper leverage you put your stop loss at the level which is next to impossible to be hit. If you have no loss at all then you will have unlimited reward.

 

 

 

OK, this is for fun but it is important. If you want to approach trading as a gamble, you need to study a lot about probability. When you talk about probability in trading, these things below are worth to be mentioned:

  • The law of large numbers.
  • Bayes’ theorem.
  • Gambler’s Fallacy / Monte Carlo Fallacy.
  • Martingale and anti-martingale.
  • Murphy’s law.

 

This topic is too big, I could write another book talking about probability alone.  I will give you just the summary and my brief opinions about them and how to apply to Forex Trading:

  • The law of large numbers talks about if you toss a fair coin about 1,000,000 times, the heads-to-tails ratio will be extremely close to 1:1. However, if the same coin is tossed only 10 times, the ratio will likely not be 1:1, and in fact might come out far different, say 3:7 or even 0:10.

 

Forex Trading Applications:

  • If you feel that you have found a magic pattern that will give you high percentage of winning ratio, you might reconsider it carefully. You most probably fall into this law; your sampling is not big enough so that you will think than you have a high percentage of winning ratio.

 

  • The probability of flipping a head after having already flipped 20 heads in a row is simply 50:50 (in a very big sample). This is an application of Bayes’ theorem.

Gambler’s Fallacy / Monte Carlo Fallacy is the mistaken belief that, if something happens more frequently during some period, it will happen less frequently in the future, or vice versa.

 

Forex Trading Applications:

  • When you see that price has going up for several times in a row, it is false to assume that next time the probability of the price going up will decrease. The probability is always the same, 50:50.

 

  • The heads-to-tails ratio of a fair coin tossed in the long run is 50:50. The probability that you guess it correctly is 50% if you choose only head all the time. BUT if you go back and forth between head or tail, the probability that you will guess correctly will come down to 25%.

 

Forex Trading Applications:

  • If you choose only one direction every time you enter the market, your probability of guessing the correct direction is 50:50. But the probability that you win that trade is less than 50:50 because of the transaction costs. I will give you example to make it easier to explain. If you have risk reward of 1:1, 10 pips stop loss and 10 pips target profit and you have 2 pips spread, you will have 50% chance to guess correctly where the price is going to be if you guess only one direction every time you trade. But since there is spread involved, you can not maintain 1:1 risk reward ratio of 10 pips SL and 10 TP. In actual the price will only moves 8 pips down and already takes you 10 pips SL. If your SL is less than your TP, your SL will be hit more frequently than your TP.
  • If you go back and forth between up or down the price will be, then you only have chance of 25% to guess correctly where the price is going to be. Since you only have 25% to be correct, your risk reward ratio should be at least 1:4 (because of the transaction costs I mentioned above). And if you have risk reward of 1:4, your TP is at least 4 times bigger than your SL. Since your TP is bigger at least your TP, your SL will be hit at least 4 times more frequently than your TP.

 

  • Martingale is a gambler’s strategy that the gambler double his bet after every loss, so that the first win would recover all previous losses plus win a profit equal to the original stake.

 

Anti martingale is a gambler’s strategy that the gambler increases bets after wins, while reducing them after a loss. The perception is that the gambler will benefit from a winning streak and reducing losses while having a losing streak.

 

Murphy’s law saying that anything that can go wrong, will go wrong.

 

Forex Trading Applications:

  • The smallest contract so far is nano lot. Let see if you start martingale with 1 nano lot. TP and SL is 10 pips each. Your martingale sequences will be like this if you have lost 20 times consecutively: 1 2 4 8 16 32 64 128 256 512 1,024 2,048 4,096 8,192 16,384 32,768 65,536 131,072 262,144 524,288 1,048,576. If you have lost 19 times in a row, in your next trade you will double the last lost into 1,048,576 nano lot (~1,048 standard lot). If you still lose that trade, you will lose 1,048 x 10 pips x 10 USD = 104,800 USD.

 

If you design your martingale trading system to withstand 20 times consecutive lost, your risk reward is 1,048,576:1. You risk 104,800 USD just to get 1 cent. Do you think it is worth it?

 

What is the odd that you lose 20 times in a row? The probability is 1:(2^20), which is 1: 1,048,576. Near impossible right? Now comes the Murphy’s Law, if anything that can go wrong, will go wrong. Your martingale system will go bust eventually, it is only a matter of time.

 

  • Anti martingale gambler has the perception that he will benefit from a winning streak and reducing losses while having a losing streak. But the perception is wrong because of Bayes’ theorem and Gambler’s Fallacy / mentioned above.

 

 

In summary:

  • Forex Trading is very dangerous, especially for newbies.
  • The moment you enter Forex trading business, you are already risking 100% of your capital and can be even more than your investment.
  • Stop loss is not guaranteed to be executed. You can end up with negative balance when you use leverage.
  • Forex Trading is a very risky business. Many risk variables are beyond our control.
  • Any risks regardless of how slim the probability is, will happen eventually. It is just a matter of time.
  • Therefore always prepare for the worst. Know the worst consequences. And always use money that you can afford to lose.
  • You have to use risk:reward:probability in your analysis.
  • In short term, the probability of where the price is going to be is 50% up and 50% down.
  • The smaller your target profit or stop loss is, the higher the probability of your target profit or stop loss will be hit.
  • The bigger your target profit or stop loss is, the smaller the probability of your target profit or stop loss will be hit.
  • Do not trade Forex using gambling system, you will never win in the long run.
  • Do not use martingale and anti-martingale system. It is very dangerous and it is not worth it.
  • Risk of trade can be eliminated by using no leverage and no stop loss at all.
  • Make your trading system risk free and you will have unlimited reward.
  • By using proper leverage you can manage your risk.
  • Know all the risks involved in Forex trading. Minimize, diversify or eliminate them if possible.