Most Forex traders begin their quest to be successful in trading by looking for a bullet proof strategy or system that will make correct trades and make them rich and successful within a year or a few. Most of the newbie in trading mainly relate these systems with a very high win rate and a good reward to risk. A system having both of the mentioned characteristics would be fit to be called the Holy Grail of trading simply because they make bigger wins than losses and also win most of the time.
Most experienced traders however understand that the quest for such a system is futile, and if it exists am yet to come across one. The reason for this is that most systems can be classified as a long term, medium term, short term and the very attractive scalping systems. The short term systems include the day trading systems while the medium term systems include intraday trading systems. Most medium term to long term system users make their money from a relatively small number of win trades that made more, that is, a low win rate but a good reward to risk. The short term system users and scalpers make their money by making smaller winnings many times, that is, a high win rate but a relatively poor reward to risk. For instance trend following systems produce a low win rate but when they do win, they win big and recover losses and still leave some profit on the table.
That said; it is true to say one does not necessarily need a high win rate system to make money in Forex trading. Harder to believe for newbies is that; one does not necessarily need a good reward to risk to make money trading Forex. This is harder to believe since most newbies are taught to let their profits run and cut losses early. This is true since prices trend at times offering an opportunity for large profits (prices follow a distribution curve with fat-tails). On the other hand it is possible to make money with a poor reward to risk system if it has a high win rate, say over 90%. The reason for this high win rate is that these systems target fewer pips (close to 1 in the distribution diagram below) and hence a high probability to reach their targets.
We will cover more on distribution as related to Forex trading on a later article, for now let us stick to our topic.
Let us crunch some numbers now, to make it more vivid. Theoretically, a strategy with 50% win rate and a reward to risk of 1:1 would breakeven after a good number of trades (over 100, the more the trades the more reliable the statistics). However, the truth is that such a system would lose money due to costs such as spread and slippage. This is the reason why Forex is regarded as a minus-sum game (the winning traders make less than the amount lost by the losers because of cost associated with trading such as spread). Due to this, a system with a reward to risk of 1:1 would have to have a win rate above 50% to be profitable.
That said; a profitable Forex trader has to choose between these two extreme systems or find a balance between the two that still makes money. The Forex trading newbie have to understand that as the reward to risk reduces, the system has to increase its win rate to remain profitable and vice versa. The main thing that the newbie traders should consider is selecting a system that allows them to trade in comfort. The low win rate – good reward to risk systems may perform poorly for a long time before they get the one or two saving trades. This may subject most newbie traders to a lot of discomfort and anxiety- especially while trading with leverage.
Traders have to accept choosing systems from either side and settle for the one they feel most comfortable with. To enhance their profit and comfort as well, money management is crucial. Good use of money management will set the trader ahead of the pack and let him sleep peacefully at night without making several peeps at the trading platform.
In conclusion, there is no one single Holy Grail in this dynamic Forex market, every trader has to find what works for him or her and stick to it with discipline.