As traders we tend to see articles and posts about win ratios for trading. Win ratios are like the holy grail to new and intermediate level traders. When we talk about a win ratio as in the number of wins in relation to the number of losses expressed as a percentage, we usually want to know how low of a winning percentage you can have and still be profitable. Or we’re drawn to a strategy that promises extraordinary winning percentages.
In this article I want to take a look at the differences between a fixed base currency amount and a fixed percentage of the account balance. I’ll compare these two contrasting ideas of how much to risk per trade with three different win ratio scenarios to see which method comes out on top.
I’ve read postings under the headings of money management or capital preservation or win ratios that ask “how should I determine the amount of money I should risk per trade?” or something along those lines. What that trader is really asking is “how much of my account balance should I risk per trade?” There seems to be two ideas of how this should be done. One is that you should always trade with a fixed amount per trade. The other is that you should trade a fixed percentage of your current account balance per trade.
What I want to do is to compare and contrast these two different schools of thought to see which one provides more profits and reduces losses when tough times come along. In order to do this, I’ll need to compare apples to apples, which means certain parameters will have to be consistent.
What we need to know first is what our exit reward parameter (profit target) will be. For my personal trading, I always set my profit target to be 2:1 reward to risk at a minimum. So for every $1 risked, my target is $2 gained. We can also express this using pips in relation to our stop loss. For example, if my stop loss is 35 pips then my profit target is 70 pips or greater which is a 2:1 reward to risk. This is what will be used as a target for a trade to be considered a win. A loss would be that my stop is hit and I’m in the hole for 35 pips. This can also be expressed as a percentage of my account balance per trade. For example, I determine I’m comfortable risking 2.5% of my current account balance per trade. A trade with a target of 2:1 reward to risk will produce a 5% gain on my account balance and a loss will reduce my balance by 2.5%.
Second, each account will be funded with a hypothetical $25,000 and the opening risk amount will be 2.5% ($625 USD)which means the first trade to be taken in each account will be the exact same amount in USD. We will also assume that 28 trades will take place over the course of a month. I agree, this is rather aggressive for a Price Action trader based on D1 charts, but it’s possible that H4 charts could produce this number of trades. This is hypothetical, so the number of trades is mainly a function of providing a large enough sample size to see the possibilities of each school of thought. We are not taking into account whether the winning trade is a long or short position, where a predominance of winning or losing short positions could negatively impact the account balance via swap charges.
33% Win Ratio
The spreadsheet shown below outlines our 28 trades with a $625 USD fixed risk per trade. There are 9 wins and 19 losses over the 28 trades. This is the bare minimum number of winning trades without going below break even.
The spreadsheet shown below outlines our 28 trades with a 2.5% risk of the current account balance per trade. There are 9 wins and 19 losses over the 28 trades. This is the bare minimum number of winning trades without going below break even as well.
We can see that the ending balances have a difference $433 USD. The fixed risk per trade account came out ahead when the win ratio is very low.
50% Win Ratio
The spreadsheet shown below outlines our 28 trades with a $625 USD fixed risk per trade. There are 14 wins and 14 losses over the 28 trades. This is where we start seeing real profits being made.
The spreadsheet shown below outlines our 28 trades with a 2.5% risk of the current account balance per trade. There are 14 wins and 14 losses over the 28 trades. I think the difference in ending balances speak for themselves.
We can see that the ending balances have a difference $3,647USD. The 2.5% risk of the current account balance per trade substantially accelerated the profit total.
60% Win Ratio
The spreadsheet shown below outlines our 28 trades with a $625 USD fixed risk per trade. There are 17 wins and 11 losses over the 28 trades. This is where we start seeing extraordinary profits being made.
The spreadsheet shown below outlines our 28 trades with a 2.5% risk of the current account balance per trade. There are 17 wins and 11 losses over the 28 trades. I think the difference in ending balances speak for themselves.
We can see that the ending balances have a difference $7,333 USD. The 2.5% risk of the current account balance per trade substantially accelerated the profit total in this example as well.
It’s obvious from the spreadsheet examples that picking a risk percentage and sticking with it consistently is the correct way to go. Let me also say that inexperienced traders in the live market should risk no more that 0.5%-1.0% of their account size per trade. You’re account will grow positively and you’ll gain valuable experience in the market under live trading conditions.
As you can well imagine, this type of increase in account balance is unusual. Not many individual traders have a 60% win ration over 28 trades during a month risking 2.5% of current account balance. But, between 40-50% is quite common among experienced price action traders.
The “2% Rule”
Many traders had heard or read about the 2% rule. If you haven’t here it is: As a rule of thumb, use 2% of your current account balance as your risk amount per trade.
There are a number of problems with the 2% rule, the most glaring of which is that it’s far too large for inexperienced traders of small account sizes. The combination of inexperience (high number of losses) and outsized risk is disastrous to a small account.
The second problem is that it’s completely arbitrary. The percentage you risk per trade should initially be based on the amount you feel comfortable losing to see if your trade idea turns to profits. That amount can be expressed as a percentage of your account balance. That’s a good place to start. Use that percentage as your risk per trade of your current account balance. As your account balance grows over the month or quarter, so does the size of your risk. The idea here is that your risk grows slowly as a percentage of your account balance allowing you to integrate the increased risk into your psychological profile naturally.
Some trading ‘gurus’ on the internet say to think of a number you’re comfortable with and use that. Each trade. Basically willy-nilly. Whatever number you’re thinking of after a few wins, while you’re pumped up and feeling invincible is what you should risk. This is a recipe for disaster. Don’t pick your risk in this way! Always figure out what your risk is as a percentage of your account before making the trade. It may just splash some cold water on your face when the number you’re thinking of is 7-10% of your account balance.
There’s also the myth of betting big on the ‘low hanging fruit’ trade. This is where you see a trade that can’t possibly lose, a big ol’ hammer candle at support for instance. There is just no way this signal is a loser! Go BIG or go home! It’s low hanging fruit for Pete’s sake! This time though, it only appears that way. For some reason, maybe because no one paid attention to the larger news picture or a big data surprise, the hammer candle was run to 20 pips past the low, taking a boat load of stops with it. I’ve seen this happen. No trade is guaranteed to win, low hanging or not. I’m not saying don’t take the ‘low hanging fruit’ trade, by all means jump on these trades, but don’t bet the farm on it. Be consistent with your risk profile.
Many traders view their trading account as the amount of funds they have for trading. Of course it’s usually not the only money they have to their name. Some trading gurus on the internet talk as if the majority of individual traders have vast funds and only put a small portion in a trading account, then trade with high leverage and just enough in their accounts to not get a margin call. No worries if they lose the trade, there’s more money to put in the account! I’ve not met one non-professional trader that views their account like that. It’s unrealistic. Beginning and intermediate traders generally have smallish accounts and the amount that’s in the account is what they have to trade with. In a sense it’s segregated from their other investment funds and for good reason. It’s the amount of money they have determined they are comfortable putting at risk. Forex is high risk, but it’s a risk that can be managed by not being arbitrary when choosing an amount of risk.
One other item I wanted to mention is the idea that losing slowly by trading a consistent percentage of your current account balance is why brokers have perpetuated the myth of the 2% rule, to keep you in the game, trading until the bitter end. Think about the lunacy of that statement. If you’re losing trades then you would want to slow the bleeding in the account, not exacerbate it by picking arbitrary risk amounts. It’s called capital preservation. And if you’re losing trades consistently, it’s not the risk percentage that’s a problem, it’s your trading.
Be consistent, don’t pick an arbitrary number that you ‘feel’ comfortable trading each trade. You’ll trade too small a size when you’re in a rough patch and too large a size when you’re on a roll.
Compounding and Making a Living
I think pretty much every trader at some point during their career has decided to create a spreadsheet showing themselves the incredible advantage of compounding an unrealistically optimistic win ratio. They then say to themselves “I’ll not touch the balance for a year and I’ll be RICH!” It doesn’t work that way. Not every month is a great or even good month. Some months are break even and you feel thankful for it.
The way I like to manage my account is on a monthly basis. I let the account compound over the course of the month and then draw off the excess over and above the beginning balance. There are two advantages to this: one is that I don’t keep an excess amount of funds in my account. Although I trust my broker implicitly, there’s always the chance that they could go belly up…bankrupt. Look at MFC Global. Who from the outside would have guessed that John Corzine, with all of his experience in the financial markets, would screw that company up so badly? The second is that I like to play a game with myself to see if I can set a new profit record over a month using the same beginning account size and current account balance percentage per trade. This is not something that’s very important to me, but if it happens I have a baseline to compare my good fortune to.
There’s a lot of misinformation on the internet from trading gurus about how to determine the amount you should risk per trade from your account. I’ve shown you that just picking either an arbitrary amount per trade or an arbitrary percentage (2% for instance) is not the way to go. You must be consistent in your application of risk and reward. Your percentage of risk can be adjusted at any time, but really should only be done when you’re consistently trading well and mental mistakes are at a minimum.