World Champion reveals: The PERFECT risk-reward ratio (RRR) in trading!

Forget all strategies if you are not able to understand the real and easy mathematic from trading. I explained you in this video, the real way of risk, of reward, of hit rates and how you combine it. And no, it is not so easy like it here. No, you have to understand everything very deep in combination to the different strategies. And in this video I explain you all the stuff. Very, very deep, dear ones, risk and money management. Even just distinguishing between these two is something many people who start trading already struggle with. And that's exactly why I want to ask you to really listen carefully here. And this isn't dry or boring. It's the most essential building block for being able to make money with trading. And that's exactly what I want to explain to you today. Show you a few examples and really take you through it in depth so that you know exactly how the whole thing works. First step, money management. What is it anyway? Essentially, it focuses on what portion of your total available capital should actually be invested. How much risk capital per trade should I actually invest? Because that's already a huge issue where unfortunately many people make incredible mistakes and think they can always enter the market with 1% risk per trade or even more. No, that's absolutely wrong. You have to differentiate what are the key figures of a strategy. And that's exactly what we're going to do today. How can I limit losses in order to preserve my capital as best as possible? We absolutely have to address this question. Money management, which we're going to start with now, essentially has three basic elements. The first is the hit rate, the second is the risk reward ratio, and the third is your actual capital size. To illustrate this, I'd like to give you an example first. So on the right side here I have a chart. And now let's calculate together with a hit rate of 35% and an assumption of, let's say, 100 trades, how is it even possible to make money with this? We'll do the same with a hit rate of 50% and then we'll look at a hit rate of 85%, which is probably a bit unrealistic when trading such strategies. But let's start step by step. Let's begin by taking a look at this. Would we make money with such a strategy? What does it include? First of all, the first thing is where do I enter? So this is my entry level, and this entry level is crucial for determining where things are headed. So next I need a set take profit. A lot of people don't even have something like this. Instead they just Wait to see if the market actually reaches the point where they think it should. And that's a huge, huge, huge mistake you can make. So our target and our stop loss are simply set at 19,460. These are the key figures we absolutely need to have in advance. And that's exactly where it all begins. Most people go and say, here's a great setup I have. And then they say, okay, I'll buy now and enter the market. This is the setup. It has a hit rate of 90%. Yeah, that may be true, but where is your target for this trade? And that's the issue most people have. They haven't defined a target in advance at all. The next step is the stop loss, which I always place below the low. But does that even make sense there? A stop loss belongs where I would expect, the opposite of what I'm aiming for in the direction I've positioned myself. That means below this point, I would consider a short trade for myself with this long idea. These are things that need to be clearly defined in advance. And if you haven't gotten bored up to this point, you should pay attention now to what it's really about. So the first thing we do is enter our account size, for example. In this case, it's the equivalent in US dollars. Just so you have an idea. So what's next? Entry, stop, loss, exit. I enter all of that. All well and good. Now I can see what is the risk reward ratio for this trade. I should definitely remember that it's at 3.5. How many units am I allowed to trade? That means how many contracts am I actually allowed to trade? So that with a risk up here of 1%, I can set up my trade mathematically in such a way that I can't get into trouble. And the next thing, which is extremely important to me, is how high is this amount in euros? How many points do I achieve with the ticks and what are the fees? This all still sounds a bit dry for now, but take a look at the following. If, for example, I were to take a risk of 3% per trade up here, then I would be allowed to trade three DAX future contracts and I would have a stop. So far, everything is still clear and easy. That means with this adjustment here, we should check whether what we're doing is actually feasible at all. Because you can already see now, if I enter a risk of 0.5% per trade and I have a stop loss of 40 ticks, I can't even trade a DAX future anymore. Then I have to look For a smaller product like the ftxm, for example, of course you can do the same thing with the S and P or others as well. We have included all these markets in our tables here so that it's absolutely clear which markets I am allowed to trade with, which stop loss, size, and so on and so forth. Before we get started and go further into this, I want to tell you something. Is the hit rate really decisive for my trading? Take a look. The following is absolutely crucial from the perspective of capital protection. If, for example, I lose 10 trades in a row, then win three and then lose another 10. For example, I have a drawdown of 17 or 18%. If I'm risking 1%, what does that mean for my loss? That means if I had a losing streak of 20%, I would have to earn 25% just to get back to break even. Now if I. Let's remember the table. If I had gone through this whole process, for example, with a 3% risk per trade, or even with 2% risk, there are people who say you should do that. Then that would mean if I lose 10 trades in a row, I lose 20%. Now I win three trades again and. And then I lose another 10 trades in a row, and then I'm at a 40% drawdown, plus, let's say, 5% that I earned before. Now I would be at a 35% drawdown. And now take a look at what that actually means. And please really pay attention. If I had a 35% drawdown, then I would need to recover between 42% and 66% just to get back to zero. That means if we take a rough average, I would have to earn back a solid 50%. Let's take a look at this graphically. Here I have a beautiful chart where I've illustrated how much money you need to recover in order to get back to zero. If you stick to your percentage risk per trade, that means if you have a 20% drawdown and that's where you started, then you only have what's left. And if you continue to calculate your trades with 1 or 2% risk, it's always based on the amount you actually have available. This is where many people already start making mistakes. But now let's take a look. We've said that we need to recover 50% because we have a drawdown of a good 30%. So what does that mean? A 35% drawdown means I have to earn 50%. That means that was the size of my drawdown. And to get back to zero, I first have to earn that much since I adjust my percentage risk and my capital accordingly. I hope you followed along up to this point and have understood this so far. This is absolutely essential to understand so that drawdowns don't become too large. What does that mean in plain terms? In plain terms, it means exactly the following. You should assign a maximum drawdown of 20% to your entire trading business. Because even here you already have to earn back 25%. That's okay. That means a 5% deduction. Okay, I can deal with that. That means if I had gone down from 100 to 80 with my entire portfolio after all stop losses added up in a row, I would have to earn 25% to get back to 100. I hope that made sense up to this point. Now, let's take it a step further and understand. Alright? With my strategy, I can lose a maximum of 20% before my capital really starts to shrink drastically. Because otherwise I would need more and resistance just to get back to zero. For example, if you were to lose 80% of your assets and you still risk 2% per trade, look, you would have to earn 400% just to get back to zero. Were you aware of that? Let's get back to our nice example. So now we know that we can only tolerate a maximum drawdown risk of 20% for our entire strategy. We don't know what our hit rate is. So let's assume we have a hit rate of 35%. By the way, that's not unusual if you're doing intraday swing trading. A lot of people are going to protest now, especially those who are always polarized by these high hit rates. I can tell you that's a completely normal number. Why, just imagine, you enter a trade here, you've predefined your risk, and above all, you've decided in advance. Unless the price reaches up here, I'm not getting out of the trade until the trade gets up there. A lot can happen during that time and sometimes it takes quite a while. Which is why you must never ever delete this predefined target. Unless in the meantime you've used other mathematical approaches for yourself. But let's stick with this example, and that's clearly the approach we want to consider now. Now let's take a look at the whole thing and use a wonderful tool that's available online to see what key figures we get when we use it for ourselves. This freely available tool here, the Equity Curve Simulator, immediately shows us, for example, how large our drawdowns are and so on. For the respective processes we enter here. I enter a 35% hit rate, a risk reward ratio of 3.5 to 1. We run a simulation for 100 trades and let it calculate the whole thing 20 times. An important point, 1% risk per trade. And now take a look at what comes out down here. The largest mathematical drawdown in the first calculation is 17.3%. The largest mathematical drawdown is 20.3%. The largest mathematical drawDown just now was at 26%. I just ran a few calculations, which means that with a hit rate of 35%, we would already exceed our predefined maximum risk, which. Which we base on our total capital of a 20% drawdown. Even if all this looks fancy here, and you might be able to make a lot of money with it, mathematically it's not healthy. So now there are two levers we can work with. One lever is having a higher hit rate, but we don't have that because it's fixed. The other lever is that we need to take less risk. Let's assume we have 0.8% and simulate the whole thing. Now we see that the drawdown is still over 20%, so we can't use it. Let's go even further. And that's how I arrived at the figure of 0.5%. Especially with strategies that do not have such a high hit rate, it's still mathematically worthwhile to implement them as long as you're able to endure it. Let's take a screenshot of this so we can compare further results later. We need to become aware of the following things, and that's very, very important. At first, if we want to have high hit rates, for example, in scalping or day trading, then the risk reward ratios don't have to be that high. But we can also make an incredible amount of money with low hit rates if mathematically the risk reward ratios are really high. And that's often where the wheat is separated from the chaff. I want to show you this once. You simply need to know the following. Look, I have a market here that's moving, and here I have an idea for a quick short breakout. It should go here. This is where I enter, for example, 20 points in the DAX stop loss, 20 points lower. It's probably familiar to many that such trades are made quite often or in the s and P. $6 up and $4 stop loss. These are typical momentum trades where you have a hit rate between 65 and 70%. Absolutely achievable. But let's imagine something different. Let's suppose we want to go short here, and down here is our target 100 points lower, but our stop loss is only 20 points. That means a 100 point profit distance and a 20 point loss distance, which gives a risk reward ratio of 5. This means with this plan, I could theoretically take the trade even with a hit rate of 20%, because with a hit rate of 20%, I would mathematically make money. Of course, it's obvious that this is emotionally hard to endure. And I can tell you, I know many trader colleagues who have hit rates around 50% with risk reward ratios of 2 or 3. And mathematically that's fantastic. And that's what we're going to look at together now to see whether it really makes sense to learn that it's not the hit rate that's decisive, meaning wanting to be right, but that the mathematics behind it is much, much more important. And now we'll compare these examples mathematically. We'll start now with the trade that has a 20% with a 70% hit rate, typical breakout trading risk reward ratio of 1.1. And let's do a good number of trades, 200 in total, which is realistically achievable. And with a risk of 1% per trade, you can see, wow, what an awesome equity curve. Even the drawdown's 10%. Everything is easy and relaxed. But now let's take it a step further. We get the following key figures. We get the figure that theoretically we have a 10 to 11% drawdown. With this strategy, high hit rate, capital allocation per trade is 1% and so on. And now comes the thing that always polarizes traders. What is the maximum or minimum I can earn with this? We take the average between 290 and 90. Let's just say 170k. That's what I would earn with these trades. That's what this simulation platform mathematically spits out for me. So I can earn an 11% drawdown with this. Now let's move over to swing trading. So with a hit rate of 50%, currently I am looking at a total drawdown of exactly 6.8% right here in this account. How is that possible? The reality of the situation is actually quite simple. If you truly want to effectively minimize your overall drawdowns, then you simply have to reduce the amount of risk you are exposing to the market. What else happens then? Let's take the following example. In swing trading, look, we risk 0.7% per trade with a maximum drawdown of 12.9%. That's the maximum I can Lose from my portfolio. Please remember it's never more than 20%. Now let's look at the key figures. Here I have 2.5 to 1, which means the risk is 1 and 2.5 is my potential reward. So take a look at what you can earn with that. On average, we end up between, let's say 250k for now. With a strategy that has a much lower hit rate, we earn much more money than with a strategy where I have to be right more often simply because I'm the breakout trader, because I'm the one who wants to have higher hit rates. Remember here we had a 70% hit rate. Here we have a 50% hit rate. And now I'll show you something else so you can really understand this. This in depth using our example. Take a look here. Earlier we calculated that in our example we were able to achieve a 3.5 to 1 ratio with our sample trade. This 3.5 opportunity was the planned distance and that's the one for the risk. Now I have a 0.7% risk per trade. I've run this through many times. The largest maximum drawdown from the math is 14%. So that's okay. So with such a strategy, we can actually take on 0.7% risk per trade. It's important to know that you can lose up to 15 trades in a row. That's very important. But now comes the question, what do we earn with the same number of trades using this strategy? Here we're in the range between 90 and 370k. That means here too we have an average of about, let's say 180k. That means you can really make a lot of money with this. And now I'll tell you something. And this is the absolute essence. You can implement such a strategy in many more markets than a high frequency breakout strategy or where you have to focus on a single market. And now comes the crucial point. In intraday swing trading, we can make a lot more trades. Let's say we make 500 trades in the same period. Whereas in breakout trading, for example, we might only have 200 trades or even encounter trades or whatever else. That means we can execute many more trades within a given period X because we need much less precision and can prepare things much better. That's how it is in intraday swing trading. Our hit rate is truly around 38 to 42%. So let's assume a bad number. And look, the drawdown stays around 12%. But now comes the crucial point. Your profit ranges between 100k and 2 million crazy. Right. Now let's ask ourselves this. What kind of profit can you realistically expect to earn with such a strategy? Now let's take a closer look and compare the results. Ah, here we were at a total of $250. But that was achieved with over 200 individual trades. Here we were at what we could earn with a 70% hit rate. And now Tom says that you can earn much, much more with a hit rate of 38%. Engage with this. That's the truth. And finally, there's one more thing I absolutely want to show you. We've created a wonderful table called the Cost of Living Calculator. And we always give it to people to help them get a sense of reality. Is what they're planning to do in trading even feasible? Let's assume you have a certain amount you need each month to live, you have trading capital, and you use one contract to trade with. We just saw that it's actually not that much that's possible. If you realistically factor in a 20% drawdown, the specific terms of this financial contract has a total value equivalent to 5 points per point. And furthermore, you have a period of 18 full trading days. What does that add up to? Here you can now see how many points per day you need to generate in order to actually build wealth. And you can see here, with this approach, you will never earn the money you really need. Let's take it a step further. Look, let's assume you're allowed to trade four contracts, each with a value of $5, or let's say €5 per point of movement using the same metrics. By the way, I haven't included any taxes here. You still have your daily living expenses and your total account size to consider. And now this is where it gets truly interesting for you. You will reach the break even point if you can successfully realize at least 12 full points of profit every single day. That means you need to earn an average of 12 points from one instrument per day just to break even with your lifestyle. But of course you want to build wealth. That's what these charts here are for. It's really, really helpful to internalize this for yourself. And then you'll realize that to actually build wealth, you need to earn an average of 20 points per day, which would allow you to accumulate wealth over your 18 trading days. And that amount gets added to your account because the rest of the money you have to use for your living expenses. And a lot of people don't take this seriously. I could give you many, many more great impressions right now. I could also make the whole thing even more complicated with thousands of examples and so on. But in the end, it's about being able to determine an expected value per trade for yourself. And above all, it's about never having a drawdown of more than 20%. Base your entire trading on that. Check whether you really have enough money to be able to live off it, including covering your living expenses. And do you have a strategy that has actually been tested? And are you even able to know how many contracts, how much money per trade you are actually allowed to use? I'm curious to see how many people will leave a like for this video here because one thing is clear to me. This is the truth about trading and many people don't deal with it. And I promise you one more thing, traders. If a lot of people leave me alike and say, tom, tell us more about this, tell us something about trading psychology, then I will do that. Because you need these essential building blocks to become a successful trader. And I am aware that it's emotionally very difficult to stick with a hit rate of 35% or 40%. I know that we all want to have high hit rates, but there's one thing you need to understand. Trading is sometimes a bit like doing a headstand. And if you can do that and endure it for a long time, you will realize for yourself that it's extremely effective to take a deeper look at the path I just introduced to you. And I am happy to support you with that. I'm looking forward to seeing you soon. Thank you very much.