I have rasied the issue of risk to reward ratios in Forex Robots and other free tradings systems before but I wanted to touch on it a little more.
The power of the numbers behind a trading system can not be underestimated. Just viewing a few simple hypothetical numbers will show you exactly how important they are.
When designing a trading system or reviewing one of the free trading systems out on the web I like use a risk to reward ratio of 1.5 as starting point. This means I would like to see a mechanical system have targets 1.5 times the size of the stop. That could be 30pt target and 20pt stops or 45pt target with a 30pt stop or any other ratio of 1.5.
The reason why I like this ratio is because it is a positive number for a start. Some traders seem to like negative ratios but no me. It makes sense to have a greater win size to loss size as it gives you more room for error in your predicted strike rate. The actual size ratio of 1.5 will allow you to have a strike rate of only 41% and above to make money. At 40% you break even and below 40% you start to lose money.
I have a theory that most mechanical trading systems with sensible tradeable stops and targets will fluctate somewhere between 40-60% strike rate. So if you can create a system with the 1.5 risk to reward ratio you will find it pretty hard to lose money over a basket of trades. Worse case scenario is you end up breaking even.
Looking at it the other way. Should you had a negative risk to reward ratio of -1.5 you would have to have a strike rate of 60% to break even. So in essance you need to win 50% more trades to breakeven than the positive strike rate system.
And further, the maximum points you can win in 100 trades with the negative strike rate system you could achieve in 80 trades with the positive ratio system.
It soon becomes clear that you are swimming against a river of numbers if you trade a negative risk to reward trading system. You can control and choose your stops and targets but you can not set your strike rate. You can only esitmate that and it has a habit of being wrong. SODS law is always present in trading.
So when you view all these Free Trading Systems on the internet, in google or in emails, work out the risk to reward ratio and it should be quite clear whether or not you will make money in the long run. Don’t fall for the trading systems and EAs that have 90% strike rate but start to lose money as soon as the strike rate drops by 5-10%.
Just a thought.