Trading Psychology, When the Risk-to-Reward Rule is Broken

August 18, 2012 by Sarid Harper

Would you risk five dollars on a coin flip that rewarded you one dollar if won? Why are some traders repeatedly willing to take on huge risks for minimal rewards? It’s all about trading psychology in this post so let’s have a look at the reasoning behind such decisions.

What is the risk-to-reward rule? The risk-to-reward rule simply states that the distance from your entry to your stop-loss is roughly equal to or less than the distance from your entry to your target divided by two. That said, due to the fact that price goes up and down, up and down, it’s paramount that key price action levels are used as the primary reasoning for entering and exiting trades.

Why would someone risk five dollars and call heads on a coin flip that rewarded the winner one dollar? If you were asked to call heads or tails for each of 100 coin flips, you might expect roughly 50 of the guesses to be correct. What about luck? The probability of 60 correct guesses out of 100 is roughly 2.8%, which means that if a large number of 100-coin-flipping experiments were performed, about every 35 experiments or so, we can expect a score of 60 or better. Even if you were able to successfully call 60% of the coin flips, which as previously mentioned is very rare, risking five dollars to find out, wouldn’t earn you an A in maths.

This kind of behaviour is actually very common among traders, and it is one of the main reasons that so man traders fail to experience consistent success. I spent a couple of hours on one particular broker site, who provided a service that enabled traders to copy each other. This service enables one trader, a copier, to copy all transactions made by another trader, a guru. A guru’s performance can be assessed and monitored prior to copying them, by looking at the statistics available via their profile page.

The following information can be evaluated when qualifying a prospective guru:

  • Statistics for gains
  • Instruments traded
  • Open trades
  • Closed trades (history)

I had a look at the top 50 traders in the guru programme to find some examples of traders who broke the risk-to-reward rule, and observed that the vast majority, if not all of the traders, were. Why is breaking the risk-to-reward rule a problem? Consider the following image:

When the Risk-to-Reward Rule is Broken-4

As you can see via the graphs on the right side of the image, most of the accounts show signs of staggering draw-down, as a result of only a handful of trades. To make things clearer, let’s have a look at the open positions of the current leading guru, with no less than 3060 copiers:

When the Risk-to-Reward Rule is Broken-1

I have included lists of open trades for the second and third place gurus as well, which you will find at the end of this post.

When the Risk-to-Reward Rule is Broken-2

When the Risk-to-Reward Rule is Broken-3

Let’s calculate the risk-to-reward ratio for this guru’s top three trades:

  • USDCHF: 55-to-1
  • USDCHF: 27-to-1
  • USDJPY: 20-to-1

If you compare the above risk-to-reward ratios with my risk-to-reward rule, which requires a minimum of e.g. 1-to-2 or greater, this guru is taking a risk, many times greater. Why would anyone trade like this?

As animal trainer Karen Pryor documented in her book:

If I were to give a dolphin a fish every time it jumped, very quickly the jump would become as minimal and perfunctory as the animal could get away with. If I then stopped giving fish, the dolphin would quickly stop jumping. However, once the animal had learned to jump for fish, if I were to reinforce now the first jump, then the third, and so on at random, the behavior would be much more strongly maintained; the rewarded animal would actually jump more and more often, hoping to hit the lucky number, as it were, and the jumps might even increase in vigor.

While you’re quite right in asserting that humans are not dolphins, I think that we can still draw some parallels between the vigorous jumping of a dolphin hoping for a treat, and the vigorous trading of a human, hoping for a win. Eventually, the trader will win, just as the continuous flipping of a coin will, sooner or later, result in a heads, despite the preceding five tails.

Consider an addiction to a drug that triggers emotions, such as euphoria, artificially. Via neurotransmitters in the brain, the same feelings can also be triggered by certain outcomes (e.g. winning) to certain activities (e.g. trading). When an urgency to experience a desired emotion becomes greater, the individual automatically feels drawn to activities and frequencies of activities that can provide the required level of satisfaction. Additionally, traders often increase the degree of risk associated with trading as the urgency to experience the desired emotion increases. This is often the case when a trader experiences a string of loses and seeks revenge, which when combined with an urgency to experience a euphoric emotion, often results in a very poor emotional environment for trading.

When things are going well, we naturally feel more confident with what we’re doing. Unless you have a plan, this confidence will often appear accompanied with a desire to take on more risk, which is when things always seem to go wrong. Confidence is great and helps build courage, which is important with regards to trading, but the odds are stacked against you to a staggering degree when your risk-to-reward ratio is 55-to-1, the magic ratio of gurus.

Thank you.