Friday, March 13, 2009

The Risk to Reward Ratio, Randomness vs Logical Thinking

In the world of forex automated trading, we usually find several types of expert advisors. The most common, at least amongst the commercial automated trading community, seems to be expert advisors which have very high risk to reward ratios . This type of experts risk a much higher amount of money on each trade than the amount of money they make on any given profitable market move. Usually the risk to reward ratio of most commercial systems that use this approach stands at 10:1 or 5:1 but on some ocassions it can be as high as 100:1 or 500:1. Now I will try to give my opinion on this type of trading and why it is the most commonly followed approach of most forex commercial automated trading sellers.

First of all, it is simply a matter of probability. The higher your risk to reward ratio is, the higher the probability that the mean reversion theory will work in your favor. This theory states that the market tends to go several times through the same price levels so if a price level has been hit, it will most likely be hit again sometime in the future. One way or another, this usually transaltes in systems with higher risk to reward ratios having much better winning percentage. This, I have seen, is completely independent of the trading system you use, hence, this type of systems are working using market randomness, which is specially important when you try to capture small amounts of profit.

Nonetheless, these systems are generally not profitable because all of their gains and equity get wiped out when the market faces a worst case scenario. The systems may remain profitable for a certain amount of time but will then quickly return all profits and turn towards draw down once the market starts to go strongly against one or several of their open positions.

Then we have systems which work the opposite way, systems which have very low risk to reward ratios and try to compensate many losers with a winner. Of course, this strategy is much less marketable and it also is far more difficult to program since you need to capture a very large amount of pips on a single move. These expert advisors usually have long periods of loses, then recover everything and win with a single or a couple of trades. This systems tackle fundamental aspects of the market, therefore they have long term profitability.

You can now see that programming the first type of expert advisors is easier and also much easier to sell and market because people are winning almost all the time (although they eventually will lose money due to the inherent characteristics of these systems), while the second category is much more challenging to program because it requires a good understanding of how the market works and not just merely basing the trades on price randomness.

If you would like to learn more about commercial and free expert advisors of each of the above categories please consider buying my ebook on automated trading or subscribing to my weekly newsletter to receive updates and check the live and demo accounts I am running with several expert advisors. I hope you enjoyed the article !

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