Let’s play a game…
We’re going to bet on 100 coin tosses… Heads, we win $100. Tails, you win $100. And at the end of the game we’ll settle up. How do you think you’ll do?
You might win or lose a little… But with 50% odds on each toss, you’ll likely break even.
So let’s change it up…
This time, we’ll flip our “lucky coin,” which lands on heads 70% of the time.
We tell you this… And because of our advantage, we offer you a better payoff…
When the coin lands on heads, we still win $100.
But when it lands on tails, you win $300.
Do you want to play?
A lot of folks would hesitate. A 70% chance of losing is a difficult pill to swallow.
But in the immortal words of investing legend George Soros: “It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right – and how much you lose when you’re wrong.”
Today, we’ll dig deeper into this idea. And we’ll show you what it could mean for your long-term trading results…
Let’s get back to the second round of our game – the one with our “lucky coin”…
Not surprisingly, the coin lands on heads 70 times, and it lands on tails 30 times. So you lose 70 tosses at $100 each, for a total of $7,000 in losses. And you win 30 tosses at $300 each, for a total of $9,000 in gains. All said and done, you walk away with a $2,000 profit… even though you won just 30% of the time.
Your likely hesitation to play this game demonstrates a mental error that traders often make… They only want to put on a trade when they have a great chance at making money. But that’s not always the right decision…
Just like in our coin toss example, you can make excellent returns even if you’re wrong more than half of the time… as long as you keep your losses small.
Consider this idea with a trading portfolio…
Let’s say we have a $100,000 portfolio and we put $5,000 (5%) into each trade. If any trade drops 10%, we’ll take a loss and move on. And we’ll take profits on any trade that hits a 20% gain.
In the table below, we’ll look at a summary of the results, after 100 trades, based on different win rates…
In the first column, you can see win percentages from 0% (taking a loss on every trade) to 100% (profiting on every trade). The next two columns show what your total gains and losses would be at that win percentage. And finally, the last two columns show the value of our account after the 100 trades and our overall percent return.
Of course, in a real portfolio, you’re not going to lose exactly 10% on every loser and make exactly 20% on every winner. But the idea is what’s important here…
By using this strategy, you would make a 10% profit even if you only win 40% of the time. And if you’re better at selecting trades – with a 50% or 60% win rate, for example – your returns would soar.
Now, that’s using a 2-to-1 reward-to-risk ratio (making 20% while risking 10%).
But if we let our winners ride, we can do even better…
We’ll use the same portfolio as before, but this time, we’ll close out our trades at a 30% gain, instead of 20%…
Here’s the table of our returns, at different win rates, with this new strategy…
Now, we’ve improved our breakeven win rate to less than 30%…
With a 3-to-1 reward-to-risk ratio, we can lose money on 70% of our trades and still make a 10% profit.
As your reward-to-risk ratios get bigger, your win rate can get smaller… And it won’t have a negative impact on your trading.
Here’s what you should take away from all of this…
Don’t ignore trading ideas that have enormous upside potential just because the chances of success aren’t great. As long as you limit your losses and let your winners ride, you don’t need a great win rate to make a lot of money.
Some of the best trades of your life may come from ideas that you didn’t think would work out… but because you thought about the reward and the risk, you placed the trade anyway.
Keep this in mind the next time you’re considering a trade. It could mean the difference between a mediocre and fantastic year in the markets.
Good trading,
Ben Morris and Drew McConnell
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Source: Daily Wealth