High Probability Trading – What Do You Need to Consider?

High probability trading strategies are a good starting point but you must also consider some other important metrics to help maximize your profitability.

“My best trader makes money only 63% of the time. Most traders make money only in the 50% to 55% range. That means you’re going to be wrong a lot. If that’s the case, you better make sure your losses are as small as they can be, and that your winners are bigger.”

Steve Cohen 

Most novice traders approach the concept of trading probability incorrectly. The focus is typically put on maximizing the probability of each trade’s success in a vacuum. 

Unfortunately, markets don’t work like this. As a thought experiment, consider that even most high-frequency traders like Virtu Financial have a trade success rate in the 50% range.

And that’s not because HFTs can’t devise strategies with higher win-rates, many have. They just know that a high probability of profitability isn’t a holy grail.

Suppose firms like Virtu, with access to billions in capital, could just print money with low-risk, high-probability strategies.

In that case, they’d practically own the entire US economy by the end of a month with how many times a day they trade (an academic estimated that they make 800,000 trades per day).

 The reality is that trading is much tougher and there’s no free lunch.

Here’s how it really works.

MOST high win-rate strategies have a low-profit target and a wide stop loss. That means your losses are huge and your winners are small.

The problem isn’t that traders want to have a high win-rate, it’s that many focus on maximizing win-rate at all costs, with little or no regard for other essential metrics.

Consider that factors like the size of your average win or loss and your maximum drawdown are typically inversely affected by your win-rate. 

Because markets are highly efficient, strategies with a high probability of profitability are punished with smaller wins and larger, although infrequent, losses.

Therefore, managing the probabilities of a trading strategy is a balancing act more than maximizing win-rate with no regards to other important metrics. 

Some of the best traders of all-time have a win-rate of around 50% or even well below that. Consider the following names: 

  • Mark Minervini
  • Richard Dennis
  • William O’Neil
  • David Ryan

Each of these traders has a win-rate around 50% or less.

So if maximizing win-rate isn’t the ideal focus, then what is? Profit factor, Sharpe ratio, something else?

Well, if the advice of some of recent history’s best traders is anything to go by, it’s merely maximizing the size of your winners and minimizing your losses.

This shifts the focus away from the probability of any trade being profitable to the actual bottom-line P&L in your trading account.

So let’s analyze how we could reduce the size of our losses and expand our winners’ size.

Take Small Partial Profits

If you’ve been trading for a while, you’ve probably been introduced to the concept of ‘R.’ One ‘R’ is basically one unit of trading risk.

Whatever the average amount of dollars you risk per trade is one R. To standardize things, more sophisticated traders often measure their profits in R multiples rather than dollars or percentage points.

It gives others an idea of how much they’ve been risking to earn their profits.

 The concept of R was introduced by Van Tharp, an expert on improving trading performance.

It might seem strange that when attempting to maximize the size of your trading winners, the recommendation would be to begin to take profits early.

Still, it actually helps many traders hold onto their winners for much longer.

When modeling a trading system and looking at metrics like profit targets, Sharpe ratios, profit factors, and the like, we can forget about the highly emotional side of trading.

Sure, if you’re a hyper-rational, surgical trader, this doesn’t matter, but it’s often the folks who think they’re least susceptible to these biases which are most affected by them.

Taking a small profit when your trade reaches 1R from your entry tells your brain that you did good and made a good trade.

It also makes it less painful should the market reverse against you after taking profits, because at least you took some shares off the table when you had a profit.

Of course, this is all qualitative. I haven’t modeled out why it’s optimal to take profits at a particular profit target or anything. It’s just simple psychology.

If you were partially right on the trade and de-risk, it makes it much simpler to hold onto the trade if it continues in your favor, because again, you’ve already booked a small profit.

The size of your partial profit target in terms of the percentage of your total position size isn’t immensely important. I personally like to use around 25%, but that’s just what I’ve found benefits my style and psychology the best.

This approach is often called “playing with house money,” but I think this idea is generally a fallacy.

The idea isn’t to be risk-indifferent once you’ve hit a small profit target but to ensure that you’re reducing losses on your marginal trades and allowing the bulk of your winners to run without the urge to close the position completely once you see green in your P&L.

I think Mark Minervini, the winner of several investing and trading championships, put it best.

“Never let a decent-sized gain turn into a loss. When you first enter a trade, it’s all risk… a modest gain can protect against a drawdown… I like to backstop my profit”

He mapped out his risk management priorities in this graph:

Cut Losses Quickly

The idea of cutting your trading losses quickly is a trading axiom that gets thrown around a lot. And as you’ve probably found in your trading career, most of these axioms are incorrect, but this is one exception.

Cutting losses quickly doesn’t mean to just close trades soon as you see red in your P&L. It’s better to approach this issue as one discipline.

The best traders don’t even need to cut their losses quickly because they’ve decided where and how to cut their losses before they even enter a trade.

Reducing the size of your losses isn’t about having a super tight stop loss. It’s about setting reasonable risk levels that are proportional to your profit targets and sticking to the game plan.

A stop loss is only as good as your discipline not to move it or cancel it altogether.

As traders, we hear a lot about ideal risk-to-reward ratios.

Many will tell you that you should aim for a specific ratio, maybe 3:1 or better.

And while that’s certainly what most market wizards and highly successful traders recommend, I’ve seen successful traders like Adam Grimes excel without adhering to this mantra.

Instead, attempting to reduce your average loss size revolves around things like closing trades that clearly aren’t working before they hit your stop loss.

I know I’m guilty of letting a lousy trade run longer than it should have because it hasn’t hit my stop loss yet. When the price action tells you to get out before your stop is hit, listen to the market.

Bottom Line

I don’t remember reading any of the Market Wizards from Jack Schwager’s several awesome books stress about having a high win-rate. Instead, it’s the exact opposite.

Follow the breadcrumbs of success and consider why a high-probability trading strategy was even a goal in the first place.

In my experience, most of the focus on win-rate comes from the Forex world.

Because of the massive leverage offered by many offshore Forex brokers, the Forex education industry seems to focus much more on the get-rich-quick side of things.

And when you’re selling to green-pea traders, the best way to get them to hit that buy button is with the allure of never losing a trade.
Credit: Warrior Trading

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