We are inching our way towards the (holistic) high probability logic you will be using. As I said, in the end, trading can be as simple as “seeing a buyer/seller advantage, and
managing your risk well. You can see me doing this many times, but this morning (June 9, 2015) I did only that during the live session. You can go back and time and watch in the community area.
There are still some important ideas we need to cover before we focus on the specific variables we’ll be using.
70% Probability Importance
You will often see me reference this 70% win/loss ratio. I’ll explain this in more detail in level 3, but for now, I’ll just give you the facts. As an inexperienced trader, it is important to put the odds in your favor as much as possible. The less experience you have, the larger the percentage of events that will appear random to you, driving your winning percentage down.
The problem here is that there is a directly correlation between how much you win, and how many trades you will lose in a row when something changes in the market. The problem with this is that if we lose too much, too soon, we will be disabled psychologically. This is because of the great difference between ordinary life/circumstances, and Forex trading. It has to do with what we feel when our decisions result in consequences. I call this the Psychology of Consecutive Loss. In ordinary life, there are few painful consequences. In Forex trading, we could be faced with many in a row. So I wanted you to be mindful that I have important reasons for guiding you the way I am in this book and in the community. This leads in nicely to our next subject.
Risk to Reward Ratio
Risk to reward is about the relationship between how much you are putting at risk vs. how much you are targeting for your profit target.
I get the opportunity now to show you another important idea at work. One of my trader friends, who was a student for a while, loved to trade a lot. He traveled the world in search of expertise. But he was always itching to trade. This was just part of his personality that he was born with. He was quite smart and educated, having a PHD in the field of psychology.
*I think it is important to define what I mean by experienced trader. I mean this in a very specific way. Experience assumes 1. You are using complete logic 2. Your setup is unique to you, derived from the application of that logic 3. You have defined that setup in your own words, into your trading plan. Until you have these components, I do not consider
Here’s what he did. First, in his main money account, he followed his trading plan
religiously. Next, he had a dummy account where he took whatever trade he felt like taking. And finally, he had a $100 account where he did something quite extreme. He traded with no stop loss and only targeted 1 PIP of profit.
He did this for over a year, and one time, he was able to have 99 wins in a row before getting a margin call. Years earlier I had a friend who I gave the nickname “stop loss Tommy.” I gave him that name because he traded with no stop loss. He was doing amazing, ranking up 67 wins in a row. Then in about 2005, the Canadian Dollar (he was trading), went the other way, never to return for ten years to his price. These two stories illuminate an idea:
The lower your target, and greater your stop loss, the higher your winning percentage.
Before you go off the rails, there is no way to use this idea to get rich. You will always “blowout” your account at some point in time. And keep in mind that these examples I’m using represent “the best they ever did.”
But I find it useful to know this information. The next question for me was this: What is the optimal ratio – in particular for the inexperienced trader?
In 2010, we got our answer. We were trading a system with four criteria. We documented every detail in complex spread sheets. I’ll explain all of this in level 3, but the optimal Risk to Reward was .75:1. This means targeting 75 cents of profit while risking $1.
If you targeting less, it ate into your bottom line and made you less profitable. If you targeted more, it lowered your winning ratio. So we see again, that in all things, it comes down to
finding the right balance.
I knew by that time that we had to target between 70 and 80% wins in order to avoid the disabling psychology. Now I had the numbers to back it up. So I gave traders the choice to target .75:1 or 1:1. Over the years, most have settled on .75:1, recognizing that the first goal is simply to achieve the ability to earn consistent profit. Those who can’t shake the desire to “get more,” went with 1:1, all the while with me telling them that they will make less money doing that.
You see, our numbers showed that you make more money targeting .75:1 than when you target 1:1. Targeting less PIPs to make more money? Yes, less is more.
And something popular in Forex trading, 2:1, is simply out of the question. In level 3, I’ll explain exactly why you don’t want to target 2:1 as an inexperienced trader.
So as you are going to see, I am suggesting you target that optimal .75:1, and hopefully I gave you some good reasons why, even if only in an introductory way. This brings us to the next idea.
PIPs Don’t Matter
You will find a lot of traders focused on PIPs. The truth is that PIPs are relative. If your risk to reward ratio is 1:1, for example, if you get 10 PIPs or 100 PIPs, you make the same exact amount of money. And how many PIPs you get are not a function of your personal desire for them, but rather a function of the variables involved in any given trade. If the pattern we are trading has moved only 22 PIPs, for example, you aren’t going to get 100, 50, or even 22.
Your potential, as least working on your first goal of consistent profit is limited to the boundary of the pattern you are trading. You will see what I mean.
Consider another way of looking at PIPs. As a teaching question, I have asked the group “which makes you more money? 10 PIPs or 100 PIPs.
Naturally most of the traders are suspect when I ask a question like that, but most new traders want to answer 100 PIPs.
Here are the numbers. If you have $200 in your account, and make 100 PIPs at 2.5% risk, you make $5.
If you have $5000 in your account, and make 10 PIPs at the same 2.5% risk, you make $125. That’s 25 times the money targeting ten times less PIPs. My message to you? DO NOT focus on PIPs. PIPs are an irrelevant factor when it comes to decision making. In any given trade, you will manage your risk effectively, and only then find out what your potential for PIPs will be.
Now it may be that you find down the road that your particular setup has an optimal potential of 15 PIPs (or whatever the number is). Notice that the market is providing that information to you, and not the other way around.
Now it’s time to learn about a very important tool that you are going to be using in your work.