In this episode of Truth About FX, Walter pulls down the curtain on the subject of focusing on win rates versus measuring a trade’s precise risk. According to him, it is highly important to backtest using a precise risk per trade. Otherwise, centering on win rates might shadow a good system that you actually have.
Download (Duration: 3:11 / 3.65 MB)
In This Episode:
00:50 – precise risk calculator
01:56 – adjusting your system
02:28 – concentrate
Announcer: Sometimes, forex trading is a wild and wooly place to be. That’s why Hugh is here, to post your questions to Walter, the naked forex guy. Hugh’s got questions and Walter’s got the answers. Here at the Truth About FX Podcast.
Hugh: Hi, Walter. When you backtest, do you just concentrate on the win rate or do you actually go in and calculate the precise risk for each trade?
Walter: Wow, what a great question! I’ve actually been talking to some traders about this just this week because I’ve had some questions on this. This is a tricky thing because what you can do is — and I’ve done a blog post on this, a video, you can get that on the shownotes after this and I’ll link that up below this episode.
Basically, you can have a really good system. If you don’t have a precise risk calculator for every trade, it hides, it masks the fact that that’s a good system. I would say, in every case, you need to backtest using the precise risk per trade.
If you focus on the win rate, you are focusing on the wrong thing because, really, what we are interested in is on return of investment and return on risk capital more precisely. That is really what will encourage you to do.
I think it is a huge mistake to just haphazardly go through a backtest saying “I just want to see if this works” because you might not know if it works or not if you are using different lots.
Basically, different risk on every trade. If trade one has a risk of 1.4% and it is a winner then trade two has 2.5% risk and it is a loser, then you are multiplying your loser, almost doubling your loser in that case and is because you are not taking precise. You are not calculating precise lot sizes on every trade.
Now, this comes with a caveat. There is one situation when you don’t need to do this. This is when like, Hugh, if you are trading this system where every single trade has an 80 pips stop loss then, you don’t need really have to think about that.
You have to adjust it slightly as your equity goes up but it’s not that dramatic. I am talking about a system where you place your stop loss based on market action. You go, “I am going to put this above this ring higher, below this ring lower” or something like that so it’s going to vary a lot and your lot sizes can vary quite a bit as will your target most likely.
That is the way I trade and lot of traders I know trade in that way but I do know there are some traders that will just take “Look, every trade, I am going to put an 80 pips stop and I’m going to have 200 pip target and that’s just the way I am going to roll.”
If you are doing that, you still need to concentrate on getting precise risk but every trade, it’s almost going to be the exact same lot sizes. It’s only going to change over months and years during your backtesting.
That is basically how I look at it.
Hugh: That makes a lot of sense. That is a good point. I never thought about that if you are just using typical lot size. I know this one trader who only risk 8-12 pips on every trade so I think, for her, testing like that would only make a difference. That is a good point. Thanks, Walter.
Walter: No problem. See you next time.
Hugh: Yup. See you.