When I mentor traders, one of the first lessons I try to hammer home is that trading is a two-step process.
Step 1 is figuring out where an asset is going next. Step 2 is figuring out how to make money from that move.
Almost all the traders I work with believe that if they can figure out Step 1, Step 2 will simply take care of itself. This is a mistake, however.
The truth is that identifying a trade setup can become fairly mechanical and intuitive. I can spend just a few seconds looking at a price chart of any asset and tell you whether or not I see a setup.
But creating a plan to put money at risk behind that setup always takes a lot more work.
When I first started trading, my first thought when looking at a price chart was always, “How much money can I make from this trade?” Now, I ask myself, “How much can I lose? Where am I wrong if this goes the other way?”
It is natural to want to focus on the gains, but I learned the hard way that the key to longevity as a trader is to focus on capital preservation.
This means that I will frequently pass on trading opportunities. This is because the risk to reward on those opportunities simply doesn’t measure up to my standards.
For every trade I take, I want the opportunity for my reward to be three times the amount of my risk. This can very well be the most important trading lesson I can pass on to you.
Let’s go through a quick and easy example to show you what I mean.
If I have two traders in front of me, one with an 80% win rate and the other with a 50% win rate, which trader would you rather be?
Your first instinct might be to choose the trader with an 80% win rate.
But what if I told you that the trader with an 80% win rate has a risk-to-reward ratio of 1:1, while the trader with a 50% win rate has a risk-to-reward ratio of 3:1?
In other words, for every trade they take, the first trader risks $1 for a potential $1 reward, while the second trader risks $1 for a potential $3 reward.
Would that change your answer?
Let’s see how the math bears out over 10 trades for each of these traders, assuming they always risk $1 on each of their trades.
Over 10 trades, Trader #1 with the 80% win rate would win eight out of 10 trades. With a risk-to-reward ratio of 1:1, they would earn $1 on each of their 8 winning trades, while losing $1 on each of their losing trades. This nets a total return of $6.
Over 10 trades, Trader #2 with the 50% win rate would win five out of 10 trades. With a risk-to-reward ratio of 3:1, they would earn $3 on each of their winning trades, while losing $1 on each of their losing trades. This nets a total return of $10.
So you can see why aiming for a high risk-to-reward ratio is so important.
Even if we bumped up Trader #1’s win rate to 90%, they would still net a total return of $8… $2 less than Trader #2. This goes to show that you can win half of your trades – or even less than half – and still end up with a net profit in your trading account.
So why is trading still so hard? Why do most traders end up losing money over time instead of making it?
The answer, I believe, is self-sabotage and a lack of discipline. It is very difficult to accept that you may lose half, or even more than half, of the trades you take.
After going on a losing run of a few trades, many traders throw their strategy out the window and go shopping for a new one. As a result, they never fully allow their edge to play out.
Everyone wants to be a consistently successful trader. The only way to get there is to be consistent with the execution of your trades.
Remember, you don’t need to win even half of the trades you put on. You do, however, need the discipline to keep your losses small and acceptable, ensuring you have the longevity to hit those 3:1 winners over time.
Editor, Money Trends
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