Developing Better Systems : Five Tips to Develop Systems With High Average Profit to Loss Ratios

If you ask the large majority of successful manual forex traders out there what their average profit to loss ratio is, most of them will tell you that their average profitable trade is at least two or three times their average losing trade. It becomes evident when you talk with people who have been successful in trading that the use of strategies with favorable profit to loss ratios is common to most if not all of the manual traders who have achieved significant levels of profitability. It is then worth asking ourselves why most of the mechanical systems being developed by people use unsound risk to reward ratios with some systems having trades risking 100 times the average profitable trade. The reasons – highlighted in yesterday’s post – are due to the temptation to “hide risk” from the eye and come up with systems that achieve better short or medium term profitability at the expense of future draw down levels.

However – if you develop your systems with adequate analysis – it is not difficult to come up with strategies that have favorable risk to reward ratios of 2 to 1, 1 to 3 or even 1 to 5. Many of the systems I have developed have favorable profit to loss ratios and on today’s post I want to share with you five basic tips you can use to develop systems that can survive through the use of an extremely favorable risk to reward ratio. Having your systems profitable trades be – in average – higher than your loses will allow you to have a better chance at long term success although the system will become psychologically harder to trade due to a probable increases in the number of losing trades. However this is NOT always true and there are cases when systems can achieve high profit to loss ratios without sacrificing a large amount of the percentage of winning trades. Do you want to develop systems with favorable average profit to loss ratios ? Keep reading to find out five tips to help you do this.

1. The trends are your friends. Systems that have very favorable risk to reward ratios are most of the time trend following because when they are right, they need to be very right. What this means is that your system should aim to capture a movement which is very significant. The system must be able to follow profitable trades as they develop by detecting trends and following them for a long period of time. This is not only limited to daily trend following systems – like the turtle trading system – but also to systems that trade trends on the 1 or 4 hours time frames.

2. Strong trend continuation signals. The success of these systems is often based on the magnitude of the inefficiency they exploit and its relationship with trend continuations. The most successful systems with high profit to loss ratios exploit inefficiencies that are very closely related with trend continuations. If when an entry happens there is a high probability to achieve a “trend-run” then the system will be able to achieve its best possible results. The mathematical expectancy of the entries of a system is one of the most important factors in determining the profit to loss ratio, analyzing this parameter of your system will be vital for success.

3. Higher time frames. Systems with very favorable risk to reward ratios usually trade in the hourly, 4 hour or more commonly daily time frames since along these time frames we get the clearest signals for trend continuations as well as the best, well-developed trends. Building a system with a favorable risk to reward ratio within the lower time frames is very hard since execution parameters become extremely important and simulations become very hard – or sometimes impossible – to carry out with a good degree of accuracy.

4. Logic based exits are everything. When you are aiming for a high profit to loss ratio it is extremely important to develop entries that cut losses short without affecting the majority of profitable trades. Developing these exits is one of the hardest things to do but it is something necessary to achieve a better average outcome for profitable trades. This will often require you to go through a large percentage of your historical trades to analyze their outcomes and the reasons why they go against your entries. Trying to reduce the market exposure of your system through the use of adequately designed exits is a key part of the development of low risk to reward strategies.

5. Focus on appropriate profit targets. Most of the time people who attempt to code trend following systems with high profit to loss ratios will attempt to capture the biggest possible trends without any regard for the mathematical expectancy values of their entries. When you code an entry logic you should think about the trend extension this inefficiency is signaling so that you can exploit it adequately. For example a weekly trend will be hardly exploitable using a signal based on a few one hour candles while a trend lasting a few days might be exploitable this way. Determine the mathematical expectancy of your entries and what time frame and profit target fits them best.

Hopefully the above tips will give you an idea of what you need to do in order to develop a strategy with a high profit to loss ratio. Although these tips are not in themselves enough to develop such strategies they do give you a good idea of what sort of trading opportunities you need to look for and what analysis you need to do in order to bring your strategies closer to this goal.

Obviously there are systems with unfavorable risk to reward ratios that can be successful – as long as their mathematical expectancy is positive – but the postponing of risk makes these strategies difficult to evaluate and their true profitability hard to see. However when using a strategy with a high profit to loss ratio the risk will be extremely exposed and the evaluation of profitability can be done in a much easier fashion. Without a doubt, strategies with low risk to reward ratios are much more robust and trustworthy than strategies that follow the opposite direction. Proof of this is the overwhelming use of this type of strategy by traders successful in the use of both discretionary and mechanical trading techniques.

If you would like to learn more about system design and how you can build your own mechanical trading strategies with favorable risk to reward ratios please consider joining Asirikuy.com, a website filled with educational videos, trading systems, development and a sound, honest and transparent approach automated trading in general . I hope you enjoyed this article ! :o)

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