Intro:
Today we are going to talk about misconceptions about the success rate of a trader. When we start trading we think that a good trader must have 95% of success rate and that he is always right. This is absolutely not true. A trader that ‘earns’ money by trading has a clear strategy in mind that makes sure he ‘earns’ money, no matter what the success rate is. Whether that is 30%, 70% or 90%. Sometimes we can have a strategy with only a success rate of 33% (meaning ⅓ trades that succeed) that is more profitable than a strategy of 66% of success rate (meaning ⅔ that succeed). Why ? Because when there are gains they will be higher than when there are losses. In mathematics we call that expected gains. We can calculate that expected gain so when that expected gain is positive then you have a winning strategy. When this one is negative we have a losing strategy.
Let’s use math to illustrate this point (I promise it’s not advanced algebra):
Some concrete example:
Example 1: The expected gains = the probability that you win your trades multiplied by the gains you make. So for example if you have a strategy where you have a success rate of 90% and that every time you gain $20 minus the probability to lose the trade so 10%. Given the fact that there is no breakeven in trading so in this example you earn $20 90% of the time however when you lose your trade you don’t earn $20 but you lose the amount you put in the trade so for example $1000. So when you win a trade you earn $20 but when you lose $1000. Obviously you win more often then you lose because you have 90% chance to gain $20 and only 10% chance to win $1000. But when you calculate the expected gains of this example 90% multiplied by $20 minus 10% multiplied by $1000 you will realize that this is inferior to zero. In other words this is a losing strategy. So obviously if you have 3 winning trades then you will gain $60 but you only need 1 single trade to lose all your money.
While it is difficult to have an investment go all the way down to 0%, it is not impossible. Ways for this to happen could include a rug pulled token, using high leverage/margin for trading, and setting bad stop limits. To limit extremely downside exposure, you should never invest too much into risky assets or use leverage.
E(x) = 90% * $20–10% * $1000 = -$82 < 0
Let’s take a second example, this time we don’t win 80% of the time but only 50% of the time. So when we win we win $20 and when we lose (50% of the time) we only lose $10. This means that you earn more if you win then you lose when you lose. So if we calculate the expected gains here 50% multiplied by $20 minus 50% multiplied by $10 this will be superior to 0. It doesn’t really matter how much above. This is really super important for beginner traders to understand this concept of being above 0 in terms of profitability. There are many more variables to take into account but this is already one of the most important one.
It is very difficult to have a position go to 0%, granted the investment is not in a rug pull or you have proper stop limits set,
E(x) = 50% * $20–50% * $10 = $5 > 0
So as we have seen in the first example we have an expected gain that is negative so a losing strategy. In the second example it is a winning strategy because the expected gain is positive even if on the second strategy we only win 50% of the time compared to the first one and 90% of the time on the first strategy. So all this to illustrate that the success rate doesn’t really predict the gains you will have. It doesn’t mean that we don’t need high success at all. We need a decent success rate of around 50% — 70% but more importantly we need a plan. That plan will determine your overall success. Bear in mind that 90% of traders are not profitable and this is one of the reasons why you need that plan. Don’t worry we will come up with another series explaining how to elaborate that plan. There is not a specific magic plan. It all depends on who you are and what you want in life/trading. Once that is defined you will be able to start the strategy and stick to it no matter what.
Why is this important in trading ?
In a nutshell it is essential to have a strategy. This strategy can consist of different things, one of them is ‘risk management’. This is a concept that we will elaborate soon as well but in this case we can state that we never put more than 5–15% of our entire portfolio in one position. Thinking about it in this way helps understanding that earning money is a process of patience and back testing your strategy. Your gains have to be consistent without taking too many risks and wanting to have a high success rate. We need to focus more on being consistent and have better risk management.
