From Teeka Tiwari, editor, The Palm Beach Letter: Being a successful trader is not just about how many of these small bets you win or lose.
It’s all about the average returns of your winning and losing trades. If your winning trades make more money than your losing trades, you’ll be a profitable trader.
So, win rate isn’t as important as the size of your average winner versus the size of your average loser.
In trading, we call this “expectancy.”
Let me show you how expectancy works using a simple example.
Imagine I run a store and gave you an offer between two online coupons:
Coupon A “wins” 80% of the time with a 50-cent discount.
Coupon B “wins” 20% of the time with a $5 discount.
Now, ask any novice investor if they would prefer to win on their trades 80% of the time or 20% of the time. I’d bet most of them would prefer an 80% win rate.
It just seems logical: A higher win rate should mean more money.
But that’s not necessarily the best way to become profitable. Sure, winning 80% of your trades looks good. And it could lead to more profits. But that’s not always the case.
Let me show you why.
If we use Coupon A to buy 10 items, we’ll get a discount eight times. That means we’d save $4. (50 cents x 8 items = 4).
If we use Coupon B to buy the same 10 items, we’ll get a discount only two times. But we’d save $10. ($5 x 2 items = 10).
So, Coupon B actually saves you 2.5 times the money than Coupon A… even though Coupon B has a much lower “win” rate.
The same is true in stock trading.
Let’s go back to our previous example, but this time, replace the “coupons” with “trades.” Each trader has a $10,000 portfolio.
Trader A wins most of his trades but doesn’t use position risk standardization. (Remember, this means having uniform position sizes.)
[Position size is a simple strategy dressed up in a fancy name. The idea is to limit risk by deciding you won’t put more than $X or X% of your capital in any single investment. Position size becomes “uniform” when you designate the same amount (for instance, 1%) across all your positions. This limits risk by managing your exposure to any single position.]
Trader B wins less than half the time, but he uses uniform position sizes of 1% per trade.
Let’s see how they stack up.
Trader A wins 80% of the time.
Trader B wins 20% of the time.
Trader A wins 8 times out of 10. He makes an average profit of $200 on his eight winning trades. That means his overall winnings are $1,600.
But his average losses on his two losing trades are $1,000. That’s $2,000 in overall losses.
Although Trader A has a high win rate, he’s an unprofitable trader.
He’s made $1,600 in profits on eight winning trades but racked up $2,000 in losses on two losing trades because he didn’t position size correctly.
So, overall, he’s lost $400. That’s 4% of his portfolio gone, despite winning 80% of the time.
Now, let’s go to Trader B.
Trader B makes an average of $1,000 on his two winning trades. That’s $2,000 in winning profits.
But Trader B has good position sizing. So he only loses $100 (1% of $10,000) on each bad trade. He has eight losing trades, so his losses stand at $800.
So, overall, Trader B has made $1,200 in gains ($2,000 profits minus $800 losses). He’s gained 12% despite losing 80% of the time.
Despite having a lower win rate, Trader B is much more profitable than Trader A. And it’s all because of solid position sizing.
As you can see from this simple example, a lower “win rate” can actually lead to much higher returns if you have uniform position sizing.
In trading, that’s all that really matters… how much you gain when you are right and how much you lose when you are wrong.
So, what’s the bottom line here?
You don’t want to over-own losers or under-own winners. That’s why the risk across your portfolio needs to be uniform.
In the case above, Trader A over-owned his two losers. On the other hand, Trader B over-owned his two winners.
The key takeaway: As long as your average gain is larger than your average loss, you can have a lower win rate and still make lots of money.
The key is to find trades with a great deal of upside and let them run while cutting your losses on trades that are bad.
Those home run trades will more than make up for those groundouts.
Even if you miss more than you hit, your hits will be grand slams. And in PBRG’s newest small-cap advisory service, Palm Beach Confidential, we’ll be swinging for the fences.
Reeves Note: Palm Beach Letter editor Teeka Tiwari and PBRG founder Tom Dyson have teamed up to use this exact same strategy in their newest small-cap service. To learn how this strategy works, click here to watch this must-see presentation.