The high win rate trap

“It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”  – George Soros

Many novice traders assume that in order to be profitable they need to have a high win rate.
Forget about that. Win rate is completely irrelevant in trading. It does not give you any useful information about the quality of a trader or their trading strategy.

During my 15-year-long trading career I have seen many traders who were losing money in the long run, even though their win rate was 80-90%. Their trading strategy was to take small profits while their Stop Loss was huge or none. This could work for them for quite a long time, for example a couple of months or even two years, giving them a false feeling of being an amazing trader. And then suddenly one or two trades ruined their dreams of being a millionaire in a couple of years.

Imagine this scenario:

Your trading balance is $1,000.

Your take profit is $10, while you are not using any Stop Loss because you are confident that you can choose the right entry point to catch that small $10 profit and that if the market goes against you, it always turns back in your favour eventually.

You execute 98 trades with a $10 profit, so your total profit is $980.

You have almost doubled your trading balance and feel like a king of the trading world.

But then, two bad trades come and you lose $500 on each. 

Suddenly, all your hard work is gone and all your profit is wiped out. What a feeling ☹

Did you know that many professional traders do not even win half of their trades and still they are very profitable?

“It is essential to wait for trades with a good risk/reward ratio. Patience is a virtue for a trader.” – Alexander Elder

If you are patient enough and can wait for good trading opportunities with a high risk/reward ratio, you really do not have to be right very often to grow your trading account.

Imagine this scenario:

You decide to take only those trades where you can make this entry setup: Your stop loss is 10 units and your profit target is 20 units. This gives you a risk/reward ratio of 1:2.

Your first 5 trades end up losers and you are down 50 units. 

What would you think? I can honestly tell you that at this point most novice traders would lose their nerve and quit this trading strategy because they would think it was not working. 

Take a look at this table:

Those who keep going would have one profitable trade, then lose one again and then they would have a winning streak of 3 trades. 

Out of 10, only 4 were profitable. A win rate of only 40%. But the good news is that with a risk/reward ratio of 1:2, you would be slightly profitable even if your win rate was only 34%!

If you were using a Risk/Reward Ratio (RRR) of 1:3, you would only need a 26% win rate to have a profitable trading system.

Here is a formula to calculate what minimum win rate you need to be profitable with your risk/reward ratio:

Minimum win rate = 1 / (1 + Reward:Risk)

Example:
My Stop Loss (risk) is 10 units
My Take Profit (reward) is 25 units
That is an RRR of 1:2.5

My minimum win rate would be:

 1/(1+2.5) = 0.28 = 28%

As you can see, a high win rate is not always a guarantee of a super profitable trading strategy. Often, traders with lower win rates can be less risky and more profitable in the long run than those who have lots of green trades in a row. 

Bear this in mind when you decide to copy someone who has huge gains but a short trading history on eToro

As the old saying goes: “Not all that glitters is gold”.

Marian Hlinka (@FreedomFund) has 15 years of trading experience, seven of which he spent on eToro. He is very active on the eToro social news feed and other social media, creating posts and videos that discuss his strategy. 

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