How do I learn from my clients? Sometimes the best psychological trading concepts are clarified in a conversation with my private coaching clients. This is especially true when we are struggling with a difficult issue. A few weeks ago, the issue of risk to reward ratio came up with a fairly new client. He had been trading on a 1 to 1 risk to reward basis. In other words he would risk $1000 with a target profit of $1000.
How does the risk to reward ratio impact stress? We were working on his stress levels, and it became obvious to both of us that the risk to reward ratio was part of this. As we developed the conversation, I made a U-shaped motion with my finger in an attempt to correlate our emotional ability to handle the extremes of risk to reward.
The extremes give us clarity. As he pushed me to clarify my hand gesture, it occurred to me that this could be a resource for not only my clients but for all traders who follow my blog posts. Below is the visual graph that represents my finger movements.
This graph represents the extreme risk to reward ratios. At both extremes we risk psychological issues.
On the right side of the graph is a one to one risk reward and 60% profitable trades. That means if I risk $1000, then my target is also $1000. If 50% of my trades are profitable, then I break even. My profitability goes up as the percentage of winning trades goes up. So if we look at 60% winning trades, that means the average profit of one trade with one dollar of risk is $0.20. With a risk of $1000, the average profit per trade would be $200.
Brain fatigue is very expensive. If we are trading one to one and are very active with this ratio, that means we need a hyperactive brain. We’ve got to be focused. This kind of trading is usually an addiction. It is like a tedious job that requires constant attention. The psychological risk is we will exhaust our focus and become unable to concentrate and will start to take revenge trades, or be afraid to enter a trade because losses eat up our profits so quickly. We have to pedal very fast to make money.
Do you want to compete with very fast algos? As we increase our trading volume for smaller profits, we are competing with algorithms with servers right next to the exchange which are really fast and trade for pennies.
Execution costs as a percent of profits go up. As we increase the volume of trades, our execution costs go up.
On the left side of the graph is a high risk, high return strategy. What happens if we make the occasional trade and expect a 20 to 1 payout? That means we are not going to trade very often. That also means that we’re going to lose 90% of our trades. The psychological risk here is significant. With a number of losses our brain chemistry shifts. We can’t help that. We lose our confidence. And we risk account drawdown because our winning trades and not going come neatly after nine losing trades. We could easily go 20 trades before we get a big payout.. Very few traders have the ability to withstand that many losses before they experience a profitable trade.
So, where is the sweet spot? This will vary for every trader. Some traders want to be more active and are willing to have a lower win ratio with more trades. Other traders are going to want to do swing trades or trades that have a bigger payout with fewer trades. But if I look at the successful traders who’ve worked with me, the sweet spot for risk to reward tends to be in the 3 or 4 to 1 ratio.
What is the advantage of finding your own sweet spot? The advantage of having the sweet spot of risk to reward is that you get enough reward psychologically to stay on an even keel. You are able to manage the losses because you have enough rewards. It reduces the risk of account drawdown because you don’t have to wait as long through losses to find out if your strategy does in fact pay out according to your theory.
You are capable of focusing without mental exhaustion. At the same time there is enough market opportunity to keep you interested. Also, the execution cost of the bid offer spreads, the stop outs and the commissions become reasonable.
Want to clarify your own sweet spot? I have created a spreadsheet that allows you to put in the variables of risk and reward that gives you a likelihood of a string of losing trades and allows your rational brain to have a conversation with your emotional needs. This spreadsheet is for our Mind Muscles Community members. If you want to know more about how to become a member and access our information, click here to find out how. Click here to get personal support with my Private Coaching.
A veteran broker and floor trader, Rich went from the "worst trainee trader ever", to building one of the most consistently profitable options trading firms on the Pacific Exchange by training his traders using neuroscience. Rich also holds a Masters Degree in Clinical Psychology, a B.A. in Philosophy, and is a graduate of the Gestalt Institute in San Francisco along with Master’s training in Neuro Linguistic Programming (NLP).
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