OPTIMIZE YOUR STRATEGY: EXPECTED VALUE VS RATIO RISK/REWARD

TAKE YOUR TRADING TO THE NEXT LEVEL

Do you have a modest account? You might be falling into this trap: taking excessive risks and making trades with low probabilities of success. Not all trades have the potential to generate optimal results. However, there are trading methods that allow you to tilt the odds in your favor, even when not all outcomes are ideal (we know that losses are inevitable).

Our perceptions of GAINS AND LOSSES are often DISTORTED by preconceived and GENERALIZED ideas about SUCCESS AND FAILURE. According to mass psychology and behavioral finance, people frequently have misconceptions about these two aspects: for example, they do not consider the herd effect, meaning they imitate others' decisions without conducting their own analysis; they overestimate their market prediction ability; they cling to losing investments instead of limiting losses, leading to greater setbacks; they confuse luck with skill; they allow emotions to guide their decisions; they neglect their basic financial principles; they lack a clear investment plan; they overlook the tax implications of their financial decisions, among others.

So, WHAT DO WINNING AND LOSING MEAN TO YOU? You may have thought that winning is increasing your capital and losing is decreasing it. However, when applying these concepts to TRADING or investments, the situation becomes more complex.

A RECOGNIZED TRADER had been trying to make profits for over a year with a strategy that, according to him, was successful due to ITS HIGH PROBABILITY OF POSITIVE RESULTS. However, out of 100 attempts, 95 TURNED OUT TO BE FAILURES, but only 5 successes were enough to exponentially multiply his capital.

Therefore, on this occasion we will focus not on the frequency of your losses, but on how much you lose when you lose, how much you gain when you gain, and how to clearly establish these ratios to improve your results.

I will introduce you to a simple method to establish your own criteria for measuring profits and losses in cryptocurrency trading.

What is the Risk/Reward Ratio?

It refers to the ratio between the amount of capital you are willing to risk (risk) and the amount you expect to gain (profit) in a trade.

Before continuing, it is crucial to understand that to establish an appropriate risk/reward ratio, where the reward justifies the assumed risk, it is essential to determine an appropriate ENTRY POINT. For example: If you split the same trade and execute it at different levels with different profit targets and risks. When the first entry carries a higher risk, the potential reward must also be greater.

If you are risking €1 but the potential profit is only €2, is it worth it? However, if you risk €1 but the potential profit is at least €3, the perspective may change when evaluating whether the risk is justifiable.

Therefore, your entry point will largely determine whether your operation develops in search of your maximum profit and how this decreases based on a lower risk.

As a consequence, as you reduce your risk, the value of your potential gain also decreases, or in terms of time, the time you will have to wait to obtain an attractive return increases ( this last applied more to investments ).

In the context of a trade, a risk/reward ratio of 1:3 means that you are willing to risk one monetary unit to gain three units of profit. The same applies when considering ratios of 1:2, 1:5, etc.

Going back to the case of the trader who made more profits with 5 positive trades than losses with 95 negative trades, how is this possible? Let me explain:

The key lies in the asymmetry of operations. Although negative operations can result in losses, the magnitude of these losses is limited by the risk-reward ratio. On the other hand, positive operations, although less frequent, generate gains that far exceed the accumulated losses. It's like having a series of small losses and a limited number of large gains, resulting in an overall positive balance.

Trading Example with Ethereum (ETH)

Let's imagine that you are considering making a trade with Ethereum. Let's assume that currently, the price of ETH is €1,900 per unit. You want to establish a risk/reward ratio of 1:3 in your trade. To achieve this, you must first determine your risk level and set your stop-loss and take-profit accordingly.

Stop-loss (SL): If you are willing to risk 1€ per unit, and you have 100€, you could acquire approximately 0.053 units of Ethereum (100 / 1900 = 0.053). Therefore, your stop-loss could be set around 0.053 units below your entry point.

Take-profit (TP): With a risk/reward ratio of 1:3, your take-profit should be three times greater than your stop-loss. If your stop-loss is, for example, 10€ below your entry point, your take-profit should be 30€ above your entry point.

This ratio assumes a system that when it wins, it does so three times as much as when it loses, although this is not always the case. It will depend on the percentage of correct predictions that your system has.

And this is where the MATHEMATICAL EXPECTATION comes into play, which helps us evaluate whether a system is profitable or not in the long run. In other words, if you will be able to achieve a good long-term return regardless of the percentage of losses (, which is what the trader in the example achieved ).

The formula is as follows: (Winning trades percentage X average profit) - (Losing trades percentage X average loss). This formula allows us to evaluate our system based on the data obtained from our long-term trades.

For example, if out of every 10 trades, 6 are positive and 4 are negative, but when you win you earn €10 and when you lose you lose €20, applying this data to our formula would look like this:

Data:

% winning trades: 0.6 in decimals (60%)

Average profit: 10€

% of losing trades: 0.4 in decimals (40%)

Average loss: 20€

EM = (0.6 x 10) - (0.4 x 20) = -0.2

As can be inferred from this operation, it is a system with negative expected value, therefore it is not viable.

In this way, the risk/benefit ratio is not everything within the system, but rather part of a whole, and to know if our ratio is the right one, we must use this type of TOOLS to determine if our system is beneficial in the long term. (You can perform this analysis with your operations from the year 2024 to improve your system and start the next year on a better foot).

Thus, you may have an asymmetry in your operations, meaning that every time you lose, you do so by double but not by triple ( you can adjust this by modifying the size of your position ) and that every time you win, you do so by triple and not by double. In the long run, and using our EM formula, you can better understand what you are doing right or wrong in numerical terms.

In the words of a renowned financial analyst, whenever you are going to make an investment or before executing a trade, ask yourself what your real profit could be ( or review your mathematical expectation), because receiving double for every euro invested is not the same as a prize worth 1000€. It will never be equivalent to invest in a cryptocurrency that has exhausted its growth potential than in one that, according to your analysis, could have a high probability of generating greater returns.

From there you will be able to determine if it is worth taking the risk.

"The main obstacle for the investor, and even his worst enemy, is probably himself." - Benjamin Graham

It's time to deepen our understanding.