From mathematical perspective the financial price movements are considered to be a random walk. The price depends on so many factors that it becomes impossible to forecast. The random walk price movement is often explained using a coin flip to determine the next day price. If the result is heads the price goes up, if the result is tails – price goes down. Thus each time the price has 50/50 chance of closing higher or lower than the previous day. Trends are formed by longer streaks of heads or tails.
That assumption is often used in some trading models and strategies. In order to make calculations more accurate we need to take into account the risk and reward as well. Let’s start with risk/reward ratio of 1. That means that we bet the same amount as we expect to win. Let’s say we flip a coin to determine if we go long or short on some stock or currency instrument. If result is heads we buy and if result is tails we sell. We set stop loss and take profit to be both 20 pips.
Having risk/reward ratio of 1 and 50% chance to win after taking several trades we should be at break-even (refer to Law of Large Numbers). But is that the case? No! Actually we’ll incur some loss. A very important thing that we didn’t calculate is the spread. Spread is always paid for each order and it changes our odds to win. If the spread is 2 pips for example, then price needs to go 18 pips to our stop loss and 22 pips to our take profit level. The chance for the price to go 22 pips further from our open price is less than the chance for the price to go 18 pips from our open price. That’s why our chance to win is not 50% anymore. Actually it has become 45% due to the spread paid.
Usually you can read experts advising that you should have a good money management strategy, change the risk/reward ratio to 1:2 or 1:3, etc. If you set the stop loss to be 20 pips and make take profit 60 pips, that will again change your odds. It will be very likely to hit stop loss and less likely to reach the take profit. Your chances to win will be 25% (without considering spread). So changing risk/reward doesn’t do anything but change our chances for win/loss and in the long run it’s not possible to overcome the negative effect of spread. Trading randomly will always give you less than 50% chance to win. And it seems there’s not much we can do about it. Let’s see how we can at least minimize the negative effect of spread in order to perform better. Here are some tips that will slightly mitigate the effect of spread and increase a bit our chance to win:
1. Set larger stop loss and take profit. The smaller the spread compared to your stop loss and take profit, the closer you get to the 50% chance of win. That means that trading on higher timeframes is preferred and the trades are kept open for longer.
2. The above tip introduces a new problem: swap. When a trade is open for several days you get paid or charged swap, depending on the national interest rates of the currencies you trade. You can only trade pairs and order types that bring positive swap but that will greatly reduce the number of trade opportunities.
3. Bet only 1-2% of your capital. It might look quite tight money management but the more you trade the higher the chance is to incur several consecutive losses. You will need enough capital to survive in such situations.
4. Try to find methods that increase your success rate. That’s the most complicated part, you can rely on fundamentals, technical analysis, patterns or anything that has more than 50% success rate. But do research yourself and test, put everything in question and don’t trust ‘incredible’ strategies you find on the internet or in books.