The Winning Hit Rate Of A Forex Trading System Is Not As Important As You May Think

Many new traders are drawn to find a forex trading system with a high accuracy rate. Hence, many promoters pander to this desire and would have you believe that the most important criteria for the best trading system is its hit rate. They often claim the system they are selling wins close to 90% of the time thereby making it a winner and highly desirable.

But does this make it one of the best currency trading systems?

Finding out the real answers as to what makes a great trading system is simple once we consider some of the mathematical principles behind them.

Only 5% achieve longer term trading success

First we must also appreciate there are many different variables as to finding out why only 5% of traders succeed in the longer term. There are some good currency trading systems on the market that cannot be successfully traded by everyone due to many different reasons ranging from failure to follow the rules of the system to failure to use appropriate money management. (Correct position size).Refer guidance on Money Management click here

On the other hand, there are many more bad currency trading systems out in the market place that will bring about a speedier demise for those that try to trade with them.

The discussion below will help you to identify two things.
First, help identify what a good forex trading system is. The second is to help identify what is the best forex trading system that fits you. There are many new advanced currency trading systems coming onto the market daily so having a good understanding as to how to find the best one without buying and trying them all will save you time and money.

50 Successful Traders with 50 Different Low Risk Methods

The first principle to a successful trading system is identified by Van K. Tharp in his book entitled "Trade Your Way To Financial Freedom" 1999. In his research he studied 50 successful traders to try and find out what they were doing. Van was looking for something that they all had in common. After he interviewed the 50 he discovered these traders all had 50 different methods of trading. One of the major key's to their success was that they all had "low-risk trading ideas".

This tells us that searching for the perfect holy grail indicator to tell us when to buy and when to sell is not needed to be successful in trading the financial markets.

Success is found in the MATHS of a trading method. Mastering "LOW RISK TRADING STRATEGIES" (Successful for those whom can follow the rules for trading the system and correct use of position sizing). Refer Trading Psychology click here

Lets get down to the maths of finding the best forex trading system. We can calculate the Expected Average profit per trade that the system should produce in the future.

Once again we have another curve ball thrown at us! What do you mean? Well, what if a system has been designed around a previous trending market and the market now goes into a period of consolidation? (choppy sideways/non-trending) or vise-versa the system has been built around a non-trending market and the market now starts to trend? Unless our system designers have built two trading strategies into the system the mathematics may not work out as anticipated.

Assuming our forex trading system can cope with this possibility we can in effect calculate the formula for the probability of success. Also called "Expectancy" of profit per trade.

Math Behind The Best Forex Trading System

Average profitability per trade = (Probability of Win x Average win) less (Probability of loss x Average loss)

For example Let's take a currency trading system that has a 50% win/loss ratio and 2:1 win/loss size ratio. (ie Wins half the time and makes twice as much as the losing trades). Say Average win size is 200 pips, Average loss is 100 pips.

The calculation is as follows;

APPT = (Probability of Win x Average win) - (Probability of loss x Average loss)

= (50% of 200 pips) - (50% of 100 pips)
= (100 pips) - (50 pips)
= 50 pips per trade "expected"

Final expectation of profit over a time period is 50 pips profit per trade on average. Which means after say 60 trades, our expectation of profit would be 3000 pips.

Another way to look at it is 30 of those trades are winners of average 200 pips = 6,000 pips.

The other 30 of those trades are losers of average 100 pips = 3,000 pips.

Net profit is winning 6,000 pips less losing 3,000pips = 3,000 pips.

(Back to 60 total trades / 3000 net profit = 50 pips per trade)

Lets consider another forex trading system with different numbers.

This time lets say out forex trading system has a 40% win/loss ratio with 4:1 win/loss size ratio. Average win is 200 pips as in the example above. Average loss is four times less, that is 50 pips.

APPT = (Probability of Win x Average win) - (Probability of loss x Average loss)

= (40% of 200 pips) - (60% of 50 pips)
= (80 pips) - (30 pips)
= 50 pips per trade "expected"
Even though our system is not as accurate as the first one, due to its win/loss size ratio, it still has the same expectancy for profit.

Opportunity to achieve expectancy very important

Another factor to consider when evaluating a forex trading system is that of "opportunity to achieve expectancy".

So far our two example forex trading systems analyzed above have come out equal as to expected profits. Both show a 50 pips profit per trade expectancy. Which one of the above systems is better will be determined by the one that has the largest frequency of trades. Remember we can expect 50 pips average per trade over the long term. Thus if the first system gave us two opportunities to trade per week we would be looking at 2 x 50 pips = 100 pips profit average per week.

Say the second forex trading system gave us opportunity to trade two times each day, that would mean we would be looking at average weekly profits of 500 pips. (2 trades x 5 days x 50 pips).

Now we can see that the second system is five times as profitable as the first one.

Other Factors with Different Trading Styles

Also bear in mind another trading style or strategy could have emphasis on another part of the mathematical formula. For example a forex trading system may have a high win rate due to close profit target. Say take profit after 15 pips with stop loss of 15 pips. This system has a 1:1 win/loss size ratio. It may have a 80% win rate, with many opportunities per day to trade. If it has 20 trades per day it could be a good system. 20 Trades with target of 15 pips per trade. It would produce net profit of 180 pips per day. Lets put the figures into our formula;

APPT = (Probability of Win x Average win) - (Probability of loss x Average loss)

= (80% of 300 pips) - (20% of 300 pips)
= (240 pips) - (60 pips)
= 180 pips per day expected

or another way to express it is as follows;

APPT = (Probability of Win x Average win) - (Probability of loss x Average loss)

= (80% of 15 pips) - (20% of 15 pips)
= (12 pips) - (3 pips)
= 9 pips per trade expected
= Assuming 20 trades per day = 20 x 9 = 180 pips per day

See how with the win/loss ratio size (1:1) being the same, a system can still be good as long as it has a good win/loss percentage (This example 80%) along with plenty of opportunity to trade.

Example of a bad currency trading system

So you want to quickly check out a forex trading system that you think is too good to be true. The advertising says 90% win rate "make what-ever-each week".

What we do is look at the prior results and compare the dollar wins to losses.

We now see many small profits and occasional huge losses. This is our alarm bell..... most of the profits can be wiped out by letting some losing trades get out of control. This shows that the currency trading system can be profitable as long as the overall market is co-operating to recover these wild losses. But the thing is..... what if the market does not co-operate and keeps going against you. That means a huge potential loss that you may not be able to recover from. When you see this type of relationship of many small profits compared to infrequent LARGE losses it shows the system is holding on to the losing positions in the hope of a turnaround. Personally I would not want to trade such as system.

Example of a REAL winning trading system

I have attached a real trading account from a large forex broker whom provides trading account history of the best performing accounts for the month which they automatically enter as a trading competition. Click here to see trading statement

The winning forex trader for the month of August 2008 achieved an increase of 434 percent.

A summary of the account is as follows;

  • 15 Winning trades for +646 pips
  • 8 losing trades 0f -86 pips
  • Made one trade each day for the month

Lets apply our expectancy formula;

APPT = (Probability of Win x Average win) - (Probability of loss x Average loss)

= (65% of 43 pips) - (35% of 11 pips)
= (28 pips) - (4 pips)
= 24 pips per trade "expected"

This means when he/she trades 23 times a month he will expect to make about 552 pips clear each month.

This persons win/loss size ratio is 7.5. That means his/her winning trades are seven and a half times larger than his/her losing trades.

That is the secret to this persons forex trading system! He / She lets their winning positions run and cuts short their losing ones. When it comes to cutting the losing trades short he/she is extremely good at it. Take a look at his winning and losing trades;

Winning trades (pips);
+66,+35,+52,+142,+78,+26,+28,+23,+16,+11,+2,+44,+41,+61,+21.

Losing trades (pips); -23,-1,-9,-21,-4,-9,-21,-19

His / Her winning hit rate of 65% may not make his system look fantastic to inexperienced traders at first glance. We can see that this person has taken the approach of sacrificing their winning hit rate in order to keep any losing trades to a minimum.

His / Her money management shows that on the persons third trade he/she took a loss of 7.5% of the account balance. As he/she was trading a very small account this percentage loss only translates to a loss of $126.75. He/she may have decided to use 7.5% of his account balance as an absolute maximum for any losses? or decided that he/she would be happy if he kept any losing trades under the $150.00 mark? For larger accounts 7.5% risk of balance would be far to much.

refer importance of money management - click here

This trading winner has a very interesting strategy in that he/she always makes one trade per day, every day.

To review actual system results for the 2008 Automated Trading Championships. Find out what made the top three forex robot systems so good, here

In summary

When you evaluate a forex trading system, the first thing to look for is small losses in comparison to the size of the profits. This is a sign that the forex trading system has mathematical credibility that passes stage one of your analysis. You want to be sure that the system is not going to let unexpected market conditions cause huge losses. Losses have to be controlled closely in the forex market to keep your trading balance healthy. You should be more than willing to sacrifice the winning percentage of correct trades for reduced risk.

As a "general rule" each loss should be about half as big as the potential winning profit. In other words 2:1 Win/Lossratio size. Systems with win/loss size's of 3:1 or above are considered in a very good light.

The old adage of letting your profits run and cutting your losses short makes sense for anyone wanting to make money in trading any market. Back in 1912 in an interview a millionaire stock market trader "E.H Harriman" was asked the secret of his immense success. He replied, "If you want to know the secretof making money in the stock market, it is this: Kill your losses. Never let a stock run against you more than three-quarters of a point, but if it goes your way, let it run. Move your stops up behind it so that it will have room to fluctuate and move higher". Where did Harriman learn this? He ran a brokerage firm that allowed him to study what separated successful traders from the others.

It is important to note that the mathematical formula for winning trading systems can have emphasis on different parts. That means that we cannot be dogmatic about what the actual trading formula should be for success in every case. For example, we saw above a system with a 1:1 win/loss size perform well because the win/loss hit rate was 80% with many opportunities to trade. Also we saw the real life account of the trader whom traded only once per day with a win/loss size of 7.5 and win/loss hit rate of 65% perform extremely well too.

With all these different variables we also need to consider yet another - that of the Drawdown Size.

Drawdown

Taking into account all that we have discussed another quick way to check to see if our system is good is to look at the drawdown size. The draw down shows the maximum amount of money our system loses from its highest point before it recovers.

We would like to see as low as possible the drawdown size so as to keep our trading account balance as safe as possible.

A smooth steady rising equity curve is best. We do not want to see large sharp drawdowns.

Can you trade the system as required?

If the currency trading system statistics seem good, you now want to consider if you can potentially trade the system to obtain similar results. Does the system require that you stay glued to the computer screen for hours on end? Do you want to trade that way? Or Do you only want to spend 20 minutes a day trading end of day data? All these decisions need to beaddressed. Automated trading systems known as trading robots or expert advisors may assist with this. For further information automated forex trading click here.

System Reviews

The final step is to try and find any forex trading system reviews from prior buyers of that particular forex system to see what the general customer feedback is. What do other people have to say about their real life trading experience with this particular forex trading system? Does it hold up in the real trading environment?

A word of warning - Unscrupulous competitors can send in bad reviews about their competition or arrange to have sent in positive reviews about their own products or services. Also, the review site might not be as independent as it claims. So remember, you will need to use your discernment.

The best forex trading system will have good mathematical ratios as discussed at the outset of this discussion, will also allow for good opportunity as to the number of trades it produces, will have a smooth equity draw down curve, will also fit into your trading time schedule / lifestyle.

Safety Net

Also, don't forget if you purchase a forex trading system through Clickbank you have the standard 60 day money back guarantee as a safety net if you are not happy with the performance of the system and you feel you were taken advantage of by the hyped up advertising, then by all means request a refund.

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