# The formula for success (it's literally a formula...)

When Stephen Hawking wrote 'A Brief History of Time' he was warned that every formula he used would halve book sales (it only has one, e=mc2). This is going to be long and boring, but if you want to make money at trading then you have to understand this concept.

Well, trading is a mathematical business so you'll just have to suck it up, lol.

What I am about to reveal is the magical formula that all professionals use, it's the 'holy grail' of trading, the 'secret sauce'. That aside, if you're losing money at trading then this post is probably the most important post I'll ever write for you, it's so critical to your success.

Enough of the cheesy guru clickbait. 90% of traders who fail, fail because they can't understand this simple concept or have been taught wrong versions of it.

It's so simple, once you see it you'll think 'duh, that's so obvious !' but if that's the case, why does everyone still lose money ?...

The 'formula for success' consists of two parts which I'll break down into plain English first.

### Risk Reward ratio.

Simply put, this is how much money you are willing to risk on each trade compared to how much you are willing to take as profit. Or how much you lose on average compared to how much you win.

Hands up in class if you've been taught that you need a Risk Reward of 2:1 ? That you must try to make 2 times what you risk in every trade ? You must be willing to risk \$10 to make \$20, or \$250 to make \$500 ? Or 3:1 or 5:1 ?

Well if you believe that, that's why you're probably losing money because it's complete horseshit. Risk Reward is only half of the equation, it doesn't really matter what it is as long as the second half of the formula balances up.

And the second half of the formula is....

How often are you right ? how often does your system work out in your favour ? How often do you 'win' ? An awful lot of people claim to have astonishingly high hit rates, like 'I win 80% of my trades'. I very much doubt that, as the people who make serious money in trading usually have hit rates of less then 40%... It really doesn't matter though, because once again that's only half of the formula.

### The formula bit.

Time to get your calculators out ! Not really, it's very simple.

In plain English first,

• multiply the value of your average win by the number of times it usually wins
• multiply the value of your average loss by the number of times it usually loses
• Divide the first number by the second number
• If the answer is greater than 1, you will make money. If less than 1, you will lose money.

Simple, eh ? I'll demonstrate with some real numbers on one of the systems I personally use.

This system is my 'daily grinder'. I use it all day, every day, on every stock I trade. It's a 100% mechanical system so I don't even need to think about it. It's not a huge earner, but it works consistently in most markets, most of the time and has worked for the last 5+ years consistently. This is my boring 'wages' system.

My Risk Reward for this system is 1:1, for every dollar I stand to lose, I make a dollar.
My system wins 56% of the time, in other words, my probability ratio is 56:44.

To work out if it's a good system, you first multiply the average win amount (in this case, '1' pip/dollar/tick/unit) by the percentage that it usually wins, 56.

56 * 1 = 56.

Then you work out the same for the losing trades, lose '1 unit', 44% of the time.

44 * 1 = 44.

Now you divide the first number by the second and if the answer is greater than 1 then it's a winning system.

56 / 44 = 1.27 (greater than 1, success !!)

And that's the secret formula, duh ! lol. Ok, so lets try it with different values.

Another system has a risk reward ratio of 5:1. For every \$1 risked, it makes \$5.
The system has a winning probability ratio of 20%, it only wins 20% of the time and loses 80%.

Plug in the numbers...

20 * 5 = 100
80 * 1 = 80
100 / 80 = 1.25 (greater than 1, success !!)

In English then, for every 100 trades, it would win \$5 * 20 trades = \$100, but will lose \$1 * 80 trades = \$80. So the net profit is \$100 - \$80 = \$20. It makes money.

You can probably understand now how it works, and why the advice that you must have a reward ratio of 'X':1 is bullshit. If you win more than lose, but you lose more often than you win, you'll lose ! lol

Ok, so some real world examples now, of the difference between amateur and professional traders.

Joe is an amateur trader. He read all the stuff on YouTube and followed some gurus advice. He has a system that wins 80% of the time (and often boasts about his win ratio on internet forums). But, like all amateur traders, he just can't let the losers go. So when he loses it tends to be really big. And when he gets into a winning position, he takes profit way too early as he's afraid to give it all back. He might win 80% of the time, but for every \$10 he wins, he loses \$70 on average.

Plug in the numbers...

80(%) * 10(\$) = 800
20(%) * 70(\$) = 1400
800 / 1400 = 0.57 (less than 1, loser !)

Joe is going to lose all his money. Every 100 trades he wins \$800 but loses \$1400. Joe's future is giving handjobs behind dumpsters to pay the mortgage.

Now look at a professional trader. He's smart, he understands probability. He's no time for losing trades and cut them dead as soon as possible. And when he wins, he wins big. His system only wins 30% of the time and loses 70% of the time. But he only loses \$10 when he's wrong, and \$90 when he wins.

Plug in the numbers...

30 * 90 = 2700
70 * 10 = 700
2700 / 700 = 3.85 (much bigger than 1, winner winner chicken dinner !!)

The professional traders future is snorting cocaine off a hookers ass in Bermuda strip clubs, or maybe paying Joe for a quick tugjob behind a dumpster.

See how it works ? The amateur can have a system that wins 80% of the time and still lose money. The professional can have a system that only wins 30% of the time and still make (a lot) of money.

I said at the start about the fixed risk reward advice being bunk, so one last example.

This system makes \$10 when it wins, but loses \$25 if it doesn't. That's a risk reward of 0.4:1, never mind 2:1 or 5:1 ! But... the system wins 75% of the time and only loses 25%.

Plug in the numbers...

75 * 10 = 750
25 * 25 = 625
750 / 625 = 1.2, it still frikken wins !!!

So try and get this nonsense out of your head that you need to have high win ratios. And also the notion that you need to have positive risk reward ratios. They're two halves of one formula and only taken together can you tell if your system is going to make you money. Either one of the 'halves' can be abysmal, as long as the other 'half' balances it out.

The average professional trader will have a win probability of something like 40%, they only win maybe 40 times out of a hundred trades. But when they win, the risk reward ratios are in the order of 10:1, 20:1 and upwards. Cut your losses short, let the winners run, and even with the shittiest system in the world you can make money.

As I've mentioned in previous posts, you can literally make a trading system out of tossing a coin, a pure 50:50 probability. If you can understand the formula above, and make \$12 when you win and only lose \$10 when your wrong... you win.

Header image credit : drjohnlatham.com found via Google image search, no affiliation.

I'm a full time financial trader, mostly in Forex and Commodities. I write for fun and try to help beginner traders get started, avoiding all the mistakes that I made. I'm always happy to chat or discuss ideas so please just give me a shout in the comments !

100% of anything I earn from this post will be donated to a Steemit charity or worthy user.

Sort:

rewards must always be bigger than the risk is what I am understanding. Is this correct?

I had been trading in my past life and lost many times my life savings so trying to avoid a repeat with crypto trading. Learning everyday. Thanks.

Not necessarily... If your reward is less than your risk, then you just need to win more often than lose (as per the formula).

If you look at the last example, a winning trade = +\$10 and a losing trade = -\$25. But... if you can win 75% of the time, then you will make money. That's why the 'formula' is so important.

I will have to say that in your short time on this forum, I have learned so much from you. Stuff that I didn't know that I was supposed to be aware of. I am one of your biggest fans. Just want you to know.

aww, thanks dude ! I've met some nice people so far, so am glad to help. It's a shitty merciless business set up deliberately to take money from people who can least afford it and give it to people who don't need it. I'm just trying to even things up for us little guys(gals).

Nothing about trading is really that difficult, it's all common sense when you think about it, like in the post I made above. Just no-one thinks, they just accept what they've been told by people they shouldn't trust. Don't take anything I say for granted either, I want people to make up their own minds...

Have you ever listened to Anton Kreil? His messages on risk management are brilliant

Anton Kreil is a pompous, stuck up asshole and just about everyone hates him for being an arrogant tosser lol. However... he does know what he's talking about, he's just a stereotypical 'city guy'. It's people like him that are the enemy... lol

I've watched a few docs on him, and he does impart a lot of good info, he doesn't mess around and sugarcoat anything which is good !

Haha! Fair enough! I quite like him and am going to one of his seminars next month. Although I've watched some of his stuff and didn't learn as much as I thought I would, because some of his eye opening reveals seemed quite obvious to anyone that questions anything! But I guess to the vast majority, the idea that banks work in a certain way is a big shock.

3 years ago (edited)

I'd say first and foremost, remember he's a salesman... conflict of interest.. He very often puts down other people who have paid training courses, citing CoI, and them spams his own paid training course... Basically just salting the ground for the competition like all business men do, it's expected though.

Oh of course, I used to be in sales myself so I know the game!

I wouldn't pay for one of his training courses, especially since I don't trade the stock market, but for £25 with drinks included it'll make a good Wednesday evening I reckon.

sure, why not ? You don't sound like you need any training anyway lol. Just get as much out of the guy as possible, without making him any richer than he is, he he. It'll be nice to meet other traders anyway, it's a lonely job mostly.

Yeah, totally agreed. I'm finding it hard to find anyone that actually knows what they're talking about! Especially on crypto Twitter...I'll bin it off soon if it doesn't kick off.

My technical analysis is objectively pretty good, but there's a whole mental side I'm nowhere near mastering. That's what I'm going to meet him with the aim of improving. I mean, the guy has been in losing trades of hundreds of millions, and kept a cool head to turn it around. So, I guess he knows what he's talking about! Pompous, stuck up asshole or not ;-)

3 years ago (edited)

Yeah true. I was reading the biography of someone the other day, a famous trader (can't remember which one...) and he reckoned it was 90% discipline and sticking to the rules ie the mental side. He said that only 10% of effort should be focused on entries, which is what everyone focuses 100% on. Made sense... Explains why most people lose money...

Am not on Twitter (or Facebook, or any other social media spyware lol). But if you want to run any ideas off me then feel free, like in the other thread I'll take the contrarian view, play devils advocate.

I dunno, chuck up a chart or something and then we can argue about what we think is gonna happen lol

So how do you really feel about him? I feel like you were holding back... LOL

I actually met him a few years ago at a function and he was just a prick. Women don't belong in the city, it's a 'mans job', he's one of those types.

Saying that, I still have a lot of respect for the guy, purely because he tells the truth about trading.

Thank you for your donation to @SchoolForSDG4 and I am so glad to see kind people like you. I need a lot of things to learn from you. I am not a crypto guy.

"Joe's future is giving handjobs behind dumpsters to pay the mortgage." 😂

I agree with the basis of your post, but it's not QUITE as simple as that. There is also the question of how MUCH you put into in each investment. The maths is no longer so simple when you start to invest vastly different amounts based on the risks of what you are investing in.

Let's say you have \$300 to invest. You put it all into three low risk. low return investments. They each have a projected ROI of 20% and a success probability of 90%. The maths for that is easy.

Now you have the same \$300, but you decide to put \$30 apiece into 10 different investments. Medium risk, medium returns. Projected ROI is 100% for all of them and success probability is 65%. Again, easy calculation.

Now you take the \$300 and put it into 30 different high risk/high return investments. Projected possible ROI is 1000% and chances of success are all 10% each. Easy to calculate.

But what if you put \$100 into one low risk, low return investment, \$30 apiece into three medium risk, medium return investments and \$10 into eleven high risk, high return investments? Well you can STILL calculate it as an overall system, get a figure, and compare to your other potential investment strategies.

BUT that's not the whole story. Because now you have cast a nice wide net and diversified your portfolio. You have now vastly increased your chances of picking up erratic market behaviour in at least one investment, you've moved away from the bell curve.

Up until now you've assumed a normal distribution of probability in your calculations, it's what you've actually based your very risk and reward figures on! But now you have over populated this bell curve to the point where you must have a few outliers, those in the area beyond two standard deviations or so. If you're luck they fall on the right side of the curve and you make a lot of money. If you aren't so lucky then they fall on the other side and you lose a lot.

The same could actually be said for many small high risk investments, but in practice that is a very difficult and possibly costly portfolio to manage, and quite frankly, you must be crazy to invest like that. But investing just a third that way can be done.

But what's my point? Well the point is that probability breaks down once you start investing in enough different things. This makes it impossible to calculate the chances of success and to evaluate a portfolio on numbers alone. Note: it does not make the portfolio BETTER (though I personally prefer to spread risk and have a very diverse portfolio), it just makes it much harder to predict future performance.

3 years ago (edited)

sorry dude, I think you might have misunderstood the intended audience of the article, I write about day trading not longer term investing and building portfolios. It's aimed at people who are going to be opening single positions at a time, maybe hundreds of positions a day for anthing from a few seconds to a couple hours, completely different to building a long term portfolio.

I'm not saying your advice is wrong, it's just not applicable for short term trading. It's like playing Roulette but with the odds in your favour, just a simple game played over and over again.

I totally agree with what you said though, I manage my investment porfolio a lot different to my day trading account :-)

ah no worries man, what you said was really good advice, you should copy and paste it into an article for your own page ! I totally agree with what you said, I have long term portfolios as well, I just use day trading to make the capital I need to increase them.

Thanks for the suggestion. I'm still finding my way around Steem. I like typing longer posts, but perhaps shorter is better.

from what I can see, if you want to make money from Steemit then you need to make small posts as often as possible, at least once a day. Some of the scammers are making three sentence posts 10 times a day and creaming it in.

my posts are way too long, people keep telling me to split them up but meh, not really bothered

Point taken. Maybe I'll try to split posts / do shorter posts / do one long post a week. My objective is to maintain a high quality of post, but I guess it doesn't HAVE to be long.

3 years ago (edited)

@tradergurl I'm just going back through some of your posts, and I'm afraid that once again you have nailed it :). Are you sure you haven't found my old trading diary ;). I just really enjoy your writing.

As for those looking to fork out for newbie trading seminars!! Don't do it!! You think they just want your \$25! Hahh! When you return, tell me I was wrong. Bet they already have you email address ;). A successful guru trader spending time away from his successful trading on the porch of his beach house, to teach you trading truths for \$25, Yeah sure!

As for these gurus telling your some honest trading truths. Of course they will! How else will they gain your confidence :). There's some trading truth for ya. Now, have I started to gain your confidence? Resteemed.

thanks dude, much appreciated :-)

I just did a post on price action trading you might be interested in, nothing you don't already know but any feedback is welcome https://steemit.com/trading/@tradergurl/hunting-for-two-legged-donkeys