Which is more important win-rate or risk-reward ratio ?

Every traders must have come across this epic question of which one to give more value, high winrates or high risk-reward, winrate is – how many of your % trades tend to come out profitable, you can have a 60% winrate which is considered decent, for many experienced traders with 70-80% win rates are not uncommon, on the other side risk-to-reward ratio, is basically how much typically you make against your losers, a 1:1 of risk-reward works well most of the time, the higher the better.

When we design a strategy, algorithmic or price pattern, it will have a characteristic winrates and risk-reward, some strategy have high winrate and low risk/reward, and reverse is also true, by evaluating these we can either discard or accept that particular strategy, because it must have acceptable winrate and reward ratio both, note that a high winrate with very poor risk-reward is not useful similarly a high risk-reward but loses quite often is equally bad, therefore when we say high winrates that means, risk-reward is also fixed, typically 1:1.

This article is for day traders and not a investing or positional trading material, for investing or any long term trading clearly the focus must be towards high reward/risk ratio. you maybe losing 7 out of 10 traders but those 3 winner will make up for all losses. Warren buffet will tell you how much he loves high reward to risk and lots of buffet folks will advice you the same, but is it one fit for all? is it good for everyone, not so simple.

As we know, winrate and risk-reward runs contrary to each others, you can’t have both in favour, means for a higher profits one has to give up some portion of from winrates and vice versa, so again the same question arise, which one is more valuable – winrate or reward to risk? Let me again clarify this guidance is only for day trading. and for day trading winrates are more important than risk to reward ratio.

Why it is so, to figure out this we must understand significance if both, winrate and risk-reward, a lower winrates simply means you are doing something wrong in your analysis or make mistakes, perhaps your market knowledge is not up to the level or you lack psychological robustness, whereas a consistently high winrates means you are right path. Second the higher risk-reward means you as a trader have been able to develop a stable mind and patience. so reality is both are important but not equally for everyone, typically in the beginning of your trading career you must focus on high winrates, combined with at least 1:1 risk-reward, later when you have mastered trades, you should be improving on reward to risk, because your experience has already made you the master of trades and don’t make mistakes.

To sum up, aiming for high risk-reward comes later in the trader learning phase, and don’t fall for anyone who is giving you a black and white answers.

How adding more indicators does not increase profits

To answer this in a deterministic manner and not to confuse you further, I would first ask you to throw another important question – whether the indicators you have posses any real edge in market? By edge I mean winning tendency over and above 50%, so if your indicator have winning tendency of 56% then it has edge of 56-50 = 6%, notice that 50 is discarded, and does not become the part of our overall edge calculation. To be clear, I should mention that win rates are calculated using strategy back-testing over a sufficient time series data.

Why, we eliminated 50 part of winrate is because all kinds of financial market provides you a default edge of 50%, without doing anything on your part, basically it just means that, in an efficient markets at any points of time the tendency to go up or go down are always the same, no matter what strategy we deploy. We know that markets are not 100% efficient but for most mathematical model based strategies this still holds a solid ground. Therefore 50% is not an edge in reality, when we combine anything of 50-50 probability it will not enhance our win rate anyway, this is what our probability theory also tells us.

Lets run through a very simple example for our understanding, lets say we have three indicators A, B and C of win rates 50% each, in a mathematical language, when an indicator A is true state we have 50% probability of winning, and same goes for B and C. Now we are asking when A, B or A, B, C have simultaneously true states that time whats the winning edge ? is it more than 50 or less !!

As you figured out, they all have 0 (50-50) edge, therefor when system is stacked by A+B+C,additional stacking do not change existing edge any further.

To put it in simple words, only if an indicator have over and above 50% edge, then combined with another indicator could results in further improvements of overall winning probabilities, and we know that most of our indicators have 50% or less (most are in range of ~35%) win rates, they become less than 50% because of brokerage and late entries, so by now it should be clear, that such combination stacked up together cannot lead you to a more profitable trading system.

Does adding more indicators increase profits ?

Anyone with some experience in using algo/signals, would have certainly wondered, can adding more indicators lead to better results than single indicator? Here by term indicator I mean builtin indicators like MACD, RSI, Bollinger Bands etc or Custom indicators too.

Lets say by some logic, indicator “A” of 50% of win rate and we add another indicator “B” of 50% winrate, a compound probability should be more > 50 ?

It doesn’t work that way in financial markets, even by simple math adding two systems with  50% win rates would yield max of 50% in result. Also note that most indicators have below 50% of winrate. So basically here we are not gaining anything instead it will take a hit on your trade system.

Biggest price you pay when include many indicators, complicate your trading system which will now behaving randomly and skip signals when expected and lose synchronicity with manual analysis. Lets see why it doesn’t improve profitability.

First, all indicators are derivatives of price history so they don’t complement each others, therefore don’t expect good from such combination. Then fact remains the markets are much random and fractal in nature, in such markets a 50% win rate is not at all a win rate, rather its a random probability of zero, funny thing is from figure 50% you may think that you have got an edge of 50 out of 100.

Just think about it, if it would have performed even in single occasion, it doesn’t take expert programmers to combine 100s of indicators and trade in huge quantity.

Why is it hard to day trade options ?

Most experienced traders play options for expiry, they buy options on events when high volatility is expected. Both are positional style trades, for our day trading we can either buy or sell options, as said earlier it is not recommended to buy options on a daily basis unless high volatility is expected. Therefore we are left with options selling, let us instigate further in this.

Note hedging stocks using options is not the scope of this writing.

options day trading

First thing will come in mind is, best way to day trade will be, price-action trading, here use of “Options Strategies” is out of question as that again is for positional trading, by price action I mean, using technical things like support & resistance, candlestick patterns, trend analysis, risk-reward knowledge etc to carry out trades.

So basically we are asking, is it possible to trade options like stocks? and not use traditional “options strategies” and too much rely on news analysis etc which are main tools for any positional option trader. How we use price-actions?  obviously they will be used on underlying instrument and using that we put options trade.

Now let’s discuss what are the major issues with approach, first options prices tend to drop little earlier than underlying so you will always get the late entry making risk reward worse for you, when second selling options will have very awful risk-to-reward ratio, what this means is, if you get 2 point drop for some fall of underlying will get 3 point rise when underlying recovers, so selling options will force you to wait longer as you get stuck in a losing position, and perhaps convert your your trade to positional.

Third issue is options price will rarely be match their fair value. Fair value of options are calculated using Black scholes model. What this effectively may do to your trade entry is, you get under priced options sold or over priced bought.

Together all these factors makes up the returns limited even if you correctly predicted underlying movements, and unfortunately that’s a proven way to become loser in long term!

What types of trading algorithm exists ?

Any sorts of trading algorithms can be categorized in two broad category, A trend following system and reversal, note that a trend following does not mean some combination of certain indicators like MACD or RSI, definition of a trend following exists without any indicator, although a trend following system can be made using built in indicator. For most time trend following systems are used.

reversal signal

 

A one liner definition for trend following can  be a logic – whose nose is always ( or attempting) pointing to current price movement.

Beauty of trend following is that they always generate a signal when price based mathematical conditions are met, so you never miss any move and also due this, stop loss is built into the system, therefore money management is never an issue for trend system.

Downside of trend following is, that they suffer from significant lags, and if lags are tried to reduced, whipsaw problem starts surfacing. Usage of trend following system is suitable only for longer trade like swing trading or for investing.

Now coming to other type of signal system called Reversal, which is opposite to trend following system, they are not for everyone and you must have expert trading skills and swiftness, they can be used in intraday trading, reversal signal attempt to head-on with active trend, this is why they feel risky to many traders.

A reversal system usually gives buy/sell signal, towards the end of steep rally or fall, when slow churning moves happen they don’t generate signal. mostly you also need a stop loss to use them. reversal signal may provides you best price for entry when done with manual analysis they can be excellent day trading tool.


Regards
Abhishek K