Profits, Losses and Nonsense

If you have been trading for some time then you must have heard someone talking about risk/reward ratio. In simple terms it is same as ratio of your stop loss/ take profit targets. It is often suggested by many that risk reward ratio of a trade must be Low- sometimes 1:2 is thrown as a rule of thumb. This means your TP should be twice of your SL How does one then explain many great traders not believing in concept of stop loss. (In case you are scratching your head, pick a copy of “one up on wall street” by peter lynch or “ bird watching in lion country” by Dirk Du Toit)

Job of a trader is to generate positive cash flows. Mathematically a trader should be solely concerned with “expected return” of the trade rather than individual components that determine this. One must optimize expected return rather than stop loss or take profit or their probabilities. For any trade,

Expected return= Probability of TP x TP- Probability of SL x SL

TP= Take profit, SL= Stop Loss

Logically, one should take a trade if this expected return is higher than costs incurred in trade( brokerage etc). (One must also consider, risk adjusted return.). Now if we assume random movements in markets then its easy to see that risk reward ratio has no bearing on expected return. In fact, no matter what ratio you use you will end up losing exactly brokerage/ spread. Increasing TP will only reduce probability of TP and increase probability of SL- linearly without giving you any advantage. So, concept of risk reward ratio is inherently useless in this case.

But traders don't believe in random walk or efficient markets or else they won’t be trading. There are few who believe in “momentum trading”. They believe that once a movement starts it will continue in same direction for a long time. In this case, it becomes very obvious that small risk reward ratio will give you enormous advantage because probability of SL and TP remains same irrespective of their levels ( 50%?). Once markets starts moving in your direction they will hit TP. Else they will hit SL irrespective of their ratio.

Then, there are traders who believe that markets have their own rhythm and they cannot move unidirectional. This means after every move there is correction and retracement bringing prices to a mean level. These traders will obviously believe in keeping very high sl/tp ratio. These are the kinds who say markets dont go anywhere. Mathematically what they mean is as SL becomes large, probability of it being hit falls not linearly but exponentially giving you an edge with large SL.

But who of these two are correct? I fired up my simulator this weekend to test these theories. (I used randomly generated trades with different risk/ reward ratios for last 20 years of hourly majors data ). As it turns out, High risk reward ratio maybe BENEFICIAL in short term and in ranging markets. However over time, the edge disappears and none tend to be correct in their beliefs. Random trades will lose money irrespective of risk reward ratio, although a HIGH risk/reward ratio will result in longer survival of the account.

Naturally, if trades are not random then results change dramatically. So it's not about risk reward ratio- its about your analysis. Worrying about TP and SL ratio will only give you headache. Observe, analyze and trade. If your observation is good you will make money else you will lose money. Trading is as simple as that. Anyone who talks jargon ought to get his facts right.

Afterthought: Ideal solution to this dilemma would be to somehow determine if markets are going to be range bound or moving directionally. Then one can shift one’s strategy to gain maximum advantage from probabilities.One such tool to determine market activity is Elliot wave analysis that tells you to keep low risk reward ratio in wave 3 and wave c. In other waves keep large risk reward ratio. No wonder most of good traders use some form of market structure analysis ( if not Elliot wave).

EDIT: I have found some interesting patterns when trades are non random. I found high risk reward ratio might actually be good. I took few momentum strategies like fractal. (Buy when daily high fractal breaks, exit at close of bar- very successful in moving majors like eur,gbp yen etc).Now, interesting part is even with this momentum strategy as you increase your sl pnl improves. For EURUSD, As sl approaches 400 pips, maximum pnl is achieved and thereafter there is no further improvement in pnl- again 20 years daily data. Yet to do enough analysis. Will need to go deeper. Meanwhile found an interesting analogy to myth of risk reward ratio- A roulette at the casino gives you a 35/1 risk/reward situation, every dollar you wager could bring you $35. So your risk here is "only" $1 but your profit (if your number comes up) is $35, a very good risk/reward scenario indeed.