High Risk and High Gain vs. Low Risk and Low Gain Strategy

When it comes to analyzing Forex strategies, many traders have no problem understanding probabilities and employing prudent risk management. They know that there is often a trade-off between a high probability of winning and a bigger reward compared to the initial risk. Normally, the closer to your entry you set your stop-loss, the higher is the chance of hitting it. The farther you set your take-profit, the lower is the chance of reaching it. The opposite is also true. The trader's goal is to make sure that the expected payoff stays positive in the long-term.

However, two strategies may have the same expected payoff but differ greatly in their risk profile. For example, a strategy with 50% win rate and risk-to-reward ratio of 1.1 has an expected payoff of 0.05 — on average, you can expect that each trade will yield 0.05 of its risked amount over the course of a large number of trades. A second strategy with a win rate of 75% and a risk-to-reward ratio of 0.4 would result in the same expected payoff of 0.05. Nonetheless, both strategies would perform differently if tested on a large enough number of trades many times.

Here is the chart of 100 simulations run on a trading account with a €10,000 starting balance with 50% win rate and 1.1 R/R ratio at €100 risk per trade generated via EquityCurveSimulator.com. Notice that quite a big share of simulations run unprofitable even after 200 trades:

And here is the same simulations chart for a strategy with 75% winning rate and 0.4 R/R ratio (the expected payoff remains the same). Notice the lower average drawdown and a bigger portion of successful simulations:

This behavior depends heavily on the chosen risk profile. With a €10,000 account, a €100 risk is just 1% of the initial balance. If we switch to risking €1,000 per trade, trading with the first strategy (50% win rate) becomes even more dangerous compared to the second one:

The second strategy demonstrates greater resilience when the position sizing becomes very aggressive with fewer simulations ending up in a blown account:

Obviously, a more aggressive risk profile favors higher win rate vs. higher risk-to-reward ratio with the expected payoff being equal. What it means is that you can analyze your own trading strategy and adjust your risk per trade accordingly. Also, if you are testing multiple strategies, you can decide which one to use based on your risk tolerance.

For example, if your trading strategy is one with a high R/R but low winning rate one, it means that you should size the positions with low risk per trade. Also, if the chance comes by, you should probably switch to a strategy that has a higher probability of winning even if it means a worse risk-to-reward ratio.

If you want to ask a question on the optimal balance between probability of winning and average win size in a Forex trading strategy, feel free to ask it using our forum.