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Weekly Trading Education Article

Profitable Trading: Show Me the Numbers
By Jay Norris*
Posted: Apr 12, 2013

The only goal you should have as a trader is getting paid once a month from profits.

Before any business deal is taken seriously by either side the potential buyer must say to the seller, "Let's go over the numbers". And, as we say on the Southside of Chicago, "Money talks; bull$#!% walks".

Before any trader can hope to make monthly profits they have to ask themselves. "Do I have the numbers?"

For us there are 2 numbers that you must know the honest answer to. Or more specifically there are two outputs your trading method must yield before you can pay the bills with trading profits.

1. Winning Percentage

2. Risk / Reward

Winning percentage is important for obvious reasons but foremost it will determine how mentally tough you have to be to trade a given method. The fewer losers you have the easier it will be to stomach. Even if your method yields a 66% winning ratio you will still find it hard to deal with losing every third time out. I know one quite successful trader who loses more than he wins. Needless to say he is strong willed, and makes his money by adding to winners, and letting those profits run. I'm not going to give you generic figures on what your winning percentage should be, because I'm not familiar with your method. You on the other hand, better know in your heart, and gut, what that number is, after back-testing and forward testing your method extensively. This is a process we call benchmarking.

Benchmarking your method means keeping an updated spreadsheet recording all the signals your method generated in the markets you follow. Your first job is determining if you are going to risk your hard earned money in a trading account? To answer that you need to find out if your trading method produces a profitable benchmark, which can then be replicated in a live account. The benchmark will first determine if the method is viable, and show you when the best time to trade is for that method. Unless the method is completely automated - black-boxed - the benchmark will remain hypothetical given you cannot be expected to stay awake 24 hours per day for 5-1/2 days a week to enter every trade, and then manage those trades to the letter of your trading plan. You can however be honest with yourself in building your benchmark by recording trade entries, trade management, and trade exits based on your trading plan. While most people can do this on a spreadsheet, they have a more difficult time sticking to the letter of the plan in a live account. This is why regulators insist that industry professionals use disclaimers reminding us that trading is a risky endeavor and not suitable for all investors. They know that statistically, even if provided with a viable plan, the majority of people will not follow it, and end up losing money.

The second number you must know, and subconsciously believe in, is your risk reward ratio, or R/R. Essentially you must know how much on average you will need to risk, and this number will determine how much you need to earn. The nice thing about currency markets over the last couple of years is volatility has come down a quite a bit, meaning so has risk. It is not uncommon to be able to take day-trades and have a risk of around 15 or 20 pips, or even 10 to 15 pips in a less volatile currency such as AUDUSD. While you can get away with a risk reward of 1 to 1 if you have even a slight winning percentage, you realistically want to see one around 1.4 or better. This means for every 10 pips you risk on a trade you need to be able to earn 14 pips. This number will not stay the same either and you will need to be prepared to make adjustments per trade. If your stop loss order is going to be 17 pips, based on the previous isolated high or low, you will likely want to have an initial profit target of 24 pips, for a 1.4 r/r. By keeping your benchmark spreadsheet updated you will always have a record of your methods trades to go back and see exactly what your risk was on each trade. You can also assign yourself a maximum risk per trade which is a good idea. For my method my risk must be in-line with the type of market environment I'm in. For example if I'm in a strong bull trend my initial target will be the most recent high, therefore my risk, or stop loss order, must be an acceptable percentage of that. If I'm trying to position myself with a longer-term trend and my signal is counter to the immediate trend I need a specific retracement target of that immediate trend to justify my risk. Rules based on risk/reward are more than filters for me; I actually see them as a component of trigger.

The bottom line is trading is a business where you need to have your plans laid out ahead of time. Profitability is explicitly tied to your winning percentage, and risk/reward ratio. Your method will either provide it or it won't, and you need to know this long before you risk your first dollar in a live account.

Trading involves risk of loss and is not suitable for all investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Jay Norris is the author of "The Secret to Trading: Risk Tolerance Threshold Theory". Jay Norris will be leading the webinar “Using Risk Tolerance Levels & Volume at Price to Improve Your Trade Selection” with eSignal on Wednesday, April 17. Register now >>

*From Jay Norris’s Instablog – posted 4/6/13

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