I wrote this article on my old blog in 2009.
Another Popular Trading Rule
There are many short little pieces of popular trading wisdom. Many of them have their origin in trend following – a trading style based on catching long trends and riding them to the very end.
One of these often quoted trading rules is “Cut your losses short and let your winners run.” It means that you should not stay in a losing position too long and, on the other side, not close a winning position too soon. You want to be quick with losses and patient with profits.
When you look around the internet for trading advice, you may find basic calculations that are an “evidence” that this rule is the holy grail.
Winners Same Size as Losers: You Need 50% to B/E
Imagine you trade the ES (S&P500 index mini futures at CME). You have a quantitative strictly rule based strategy that enters the market on a technical signal and exits either on a fixed stop-loss of 4 points or on a fixed profit target of 4 points. As a result (and not assuming commissions and occasional exits on end of day or an opposite signal), your losses are the same size as your winners. In traders’ language, your reward-to-risk ratio is exactly 1:1. In this case both winners and losers are 200 dollars per contract. To at least break even in the long run, you need more than 50% of your trades to be winners.
The Beauty of Big Profits and Small Losses
Now let’s say you have a similar strategy, but this time your stop loss is only 2 points (100 dollars per contract) and profit target is 6 points (300 dollars). Not assuming commissions, your ratio of winner size to loser size (reward-to-risk or risk-reward ratio), is 3:1.
To break even, you only need 1 winner for every 3 losing trades, a winning percentage of 25%. Great, you think, this strategy is so much better than the previous one and so much safer and so much… I go for it.
The Advantages of High Reward-to-Risk Ratio
The reason why most people prefer to aim for higher reward-to-risk ratio (besides the fact that every trading website in the world promotes it) is that when executed correctly (no major breaking of the rules), it helps with risk management and psychologically it feels better. It avoids the kinds of moments when you take a big hit which shakes your confidence and harms your judgement for the following trades.
The Problem is that There Is Also the Winning Percentage Factor
In reality, achieving a certain winning percentage with smaller stops and bigger profit targets is also much more difficult. There will be times when the market will go against you 3 points after your entry. While a 2 point stop means you’re out and have just lost 100 dollars, a 4 point stop loss would keep you in the position and might have resulted in the 200 dollar win. There will also be times when the market goes 5 points in your direction, then reverses, and doesn’t stop going against you. A 4 point target means a profit for you, while a 6 point target ends in a loss.
The trade-off between reward-to-risk ratio and winning percentage is the core of all speculation. While in some kinds of markets it is better to shoot for big winners and cutting losses very fast, under other market conditions it is much better to be satisfied with winners which are about as high as losers.
Trending vs. Mean Reverting Markets
Cutting losses and riding winners (the ratio of reward to risk much greater than 1) will be profitable in markets and for time horizons where the price action shows a trending behaviour often (daily charts of some commodities like corn or oil come to my mind now). Of course you will hardly find a market which only goes up or down and never sideways. But that is not necessary at all. The higher your reward-to-risk ratio, the smaller winning percentage you need.
On the other hand, there are markets and time horizons which are mean reverting in nature, which means that they rarely make a continuous long clean move (trend) in one direction and rather make many spikes and dips, followed by the price coming back to from where it started. A closer price level is far more likely to be reached compared to a more distant price level, more than what would be “fair” given the ratio of the distances from current price. This is the kind of price action which people call “sideways” or “choppy.” The intraday chart of the S&P500 can drive a trend trader crazy on some days by being exactly this.
This Article Doesn’t Promote Large Losses
This article was not written to promote negatively skewed trading strategies – those that give you a majority of small winners and a few big losers that can erase your trading account. In fact, in my own trading endeavours, I mostly follow the cut losses ride winners rule and usually prefer tight stops and look for a profit potential of at least 1.5 to 3 times the stop loss or option premium paid or however I define risk for that particular trade.
The point of this article is that such approach is not the holy grail of trading and it does not automatically guarantee a profitable strategy. There are markets which tend to move sideways most of the time, create many false breakouts, and are quite mean reverting in general. For such markets, trend following or momentum strategies will not be successful and even the golden rule of trading, cut losses and ride winners, may not work here.
You can design a great trading strategy with profits size two times the size of losses, as well as you can design a great trading strategy with profits size half the size of losses. Base the distance of your stop-loss orders and the size of your profit targets on the way your market behaves and on the way your strategy tries to take advantage of it, and not on some sentence you have read somewhere on the internet or in a bestselling trading book. Though a rule might have worked for some trading superstar you admire, it might not work for you and your market that well.