As everyone knows, there are significant risks trading futures or any financial market. These risks are amplified by traders who enter the trading arena under-capitalized and over-leveraged. In other words, some people start trading with the unrealistic expectation of turning a small amount of money into millions in a short period of time. The fact is, if someone is trading with money they can’t afford to lose, then odds are they won’t make sound trading decisions, which will perpetuate their losses.
No matter what strategy or approach someone uses to trade, it’s vital to understand the different components of risk management. In this article we’ll dive into the top money management components.
Traders typically give “win ratio” the most attention. Also known as the “success ratio”, it is a ratio of the gross number of winning trades to the gross number of losing trades. In other areas of life, like school, people are taught to strive to be “correct” a majority of the time. While your win ratio is important, it’s not the only thing that matters. You see, it’s possible to have a very high win ratio (above 80%) and still lose money. The reason is because the win ratio doesn’t take into account the average amount gained and lost.
The reward-to-risk ratio is calculated by taking the initial expected profit target divided by the maximum allowed stop. Another way to calculate this ratio is by finding the average winning trade size divided by the average losing trade size.
For example, if we take an average profit target of 2 points on the e-mini S&P 500, and and average loss size of 1 point, then we would have a 2:1 reward-to-risk ratio. In other words, there would be $2 in expected profit for $1 risked.
This can be a difficult ratio to attempt to control for traders who don’t use automatic stops or who frequently close trades prior to their initial profit targets.
The Inverse Relationship Between Both Ratios
“With increased profit potential, there’s always increased risk”. Not only is that old trading cliche true, but it applies to every market and every time frame.
So, if you’re going for a higher win ratio, chances are your reward-to-risk ratio is going to be lower. In other words, if you want to win a high percentage of your trades, you’re likely to see a larger average loss. On the other hand, a lower win ratio could mean the potential for a larger average win size. Some traders refer to as “looking for the home run trade”. Essentially a trader would be willing to take a higher percentage of losses in search for an infrequent large winner.
There’s not a single “right combination” of win ratios and reward-to-risk ratios, and you will virtually never find a trading system that can give a fixed win ratio or reward-to-risk ratio. After all, the markets are dynamic and in a constant state of change.
See the two examples below that show an inverse relationship between win ratios and reward-to-risk ratios:
I think one of the most things to consider when balancing the two ratios is – How do I handle losses? For someone who cannot stomach a high percentage of losing trades, then maybe they would look to decrease their average winning trade size (thus giving them a higher percentage of wins). But they would need to keep in mind that by decreasing their average win size, the “weight” of the losses would be greater.
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PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE. THE RISK OF LOSS IN TRADING FUTURES CONTRACTS OR COMMODITY OPTIONS CAN BE SUBSTANTIAL, AND THEREFORE INVESTORS SHOULD UNDERSTAND THE RISKS INVOLVED IN TAKING LEVERAGED POSITIONS AND MUST ASSUME RESPONSIBILITY FOR THE RISKS ASSOCIATED WITH SUCH INVESTMENTS AND FOR THEIR RESULTS. PLEASE READ OUR FULL DISCLAIMER HERE.