The key ingredients of successful trading strategies – If you don’t understand these, you are doomed to fail
The key question here is: What do you need to win consistently? At the end of the day, traders want to make a profit. How much profit and in what period of time, are other factors to consider. Most novice traders want to “double the account” in a very short amount of time. Impatience and a lack of knowledge play a role, but also fear. Professional traders are in this business for the long run and therefore their thinking is different. According to the eastern philosopher and teacher Confucius: Time and patience are the two greatest warriors! We are mentioning the emotional and mental factors first, as they seem to be the most important key ingredient in any trading environment. Matter of fact, this is the most important success factor in almost any human endeavour that is worthwhile to pursue: Sports, Arts, Politics, Business, Relationships, etc.
If you have the right mindset and your emotions in check, then there is another set of ingredients that will – without doubt – lead to success in the financial markets. We are talking about pure mathematical factors. We often hear or read about: high probability trade setups or high probability trading strategies. How do you define if something has “a high probability”? The word “probability” comes from the world of mathematics. It describes a statistical function, with all the possible values and likelihoods of a certain outcome, within a certain range! This is important to note. If we take this into the trading world, then this means that a certain financial instrument will most likely move within a certain range. Apple Stock (NASDAQ:AAPL) is at 90.52 USD per share. Is it possible that the stock price will move tomorrow towards 91 USD? 92 USD? What about 89.75 USD? Possible? Yes, the values are very close to the actual price and chances are high, that the price level could touch any of these values within the next hours or days. Why are we so certain? Because we have seen this before. A share price move a few points in either direction. Is it possible, that Apple shares will hit 350 USD by tomorrow? It could be, but this event is highly unlikely! The probability is very low, whilst the probability of hitting a lesser value is very high. This is what traders look for in any trade setup or with any trading strategy. It does not matter, if you are a day trader, a swing trader, an institutional trader or if you are trading binary options, Forex or CFD’s. The key element is always the same: looking for events, that have a higher probable outcome than other events, within a certain period of time!
Sure, Apple shares could hit 350 USD, but that will maybe take several years. You are looking for a certain outcome within a predefined time setting. We can already see, that trading is a probabilistic game. You act upon certain expected outcomes of specific events. This makes trading actually clearer and more transparent.
The next set of key elements that lead to consistent winnings and trading profits, is related to the relationship between: the risk/reward ratio, the win/loss ratio and drawdown ratios. In another article, we will explain these ratios in more detail, but for now it is important to know, that the underlying mathematical formulas are one of the most important key factors for success in trading. Traders want to be “right” all the time. Sometimes the ego gets in the way. A “bruised ego” is a sure-fire recipe for failure. You have to think this in terms of a mathematical formula. Let’s say Trader A is 80% of the time right in his “predictions” or with his trade setups. Being 80% of the time at the “right side of the bet” could make you a millionaire in other fields of human activity (Sports betting, Weather forecasting, etc.) and yet, Trader A could be losing money on a very consistent basis. Why? Because his risk/reward ratio is poor. Do the calculation for yourself: if Trader A wins in average 50 Pounds every time he is right and loses 100 Pounds every time he was wrong, then the mathematics are against him, even if he is 80% of the time right in his assessment. He will lose 8000 Pounds and only win 1000 Pounds. Making a net loss of 7000 Pounds. Being right is not enough in this business!
For many traders this is a concept that is very difficult to grasp. How can you lose, if you were right? Trading is another world. Here you can win, despite being wrong. Successful traders have the right balance between: risk/reward, win/loss and also in relationship to drawdown (DD).
What does drawdown mean? You enter a trade. This trade has a very high probability to become a winner (therefore making you a hefty profit). This will happen in a certain period of time. Let’s say in 4 hours’ time. During this time span the price will fluctuate and swing against you or in your favour. Which means, the trade will sometimes show red figures (a hypothetical loss, if you were to close the trade immediately) and in other moments the trade will in the black (although, maybe not with the expected profit!). The “red figures” is what we call Drawdown. Some traders call this “taking the heat”. This is the amount of money you need to have in your account, in order to support and “finance” this open trade. You might end up with a very nice profit, once the trade had its run. In the meantime, you need to “endure” the negative number. Some traders panic and close – an otherwise profitable – trade. Others become impatient and close the trade. This leads to a bad risk/reward and also to a bad win/loss ratio statistic.
Any trading strategy will have moments with a drawdown. The question is: how long does the drawdown last and how deep will the drawdown go? Both questions need to be considered and are part of an excellent trading strategy.
Trading is the right balance between emotions and mathematics. If you run your calculations and keep your emotions in check, then there is no reason why you should not become a highly successful trader. In our next article we will discuss how to achieve consistently high risk/reward ratios and how to calculate a proper drawdown level.
If you don’t want to deal with the emotional side of trading or the necessary calculations, then there are other options for you: trading signals or managed accounts. We offer both options here on Smoothtrading.com Check out our section about Signal Providers. You don’t need to worry about risk/reward ratios or win/loss ratios any more! The Signal Provider has you covered and will send you trade ideas or specific trade setups, that already consider these factors. If you don’t want to bother with either of these, than try a managed account. In this case, a professional takes care of your investments and trades your money, taking these factors into consideration.