A good trading system should be designed to achieve asymmetric returns by analyzing the potential outcome of a trade and only triggering those trades where the odds are skewed in your favor using asymmetric risk and return profiles. Asymmetry is one of the variables of a trading system with potential positive expectancy, and the ability to identify trades where the probability of a positive outcome is greater than the negative is essential to a good trading strategy. This article will explore the important aspects that can help you integrate asymmetric concepts into your own futures trading strategy.
What is an asymmetric risk and return profile?
Asymmetric risk and return means that the payout of a profitable trade is significantly larger than the potential loss. It also suggests that a trader needs to control his downside, limit his losses and then look for trading opportunities with significantly larger odds for a potential profit. The phrase “cut your losses short, let your profits run” is at the core of this trading method.
A trading method with asymmetric risk and return profile is characterized by a return distribution graph with fat tails. In statistics, fat tails are used to describe a distribution where outliers have greater weight and specific return data does not cluster as strongly around the mean. In contrast, most traders’ profit distribution looks more like a normal distribution where each trade provides approximately the same outcome and data points are scattered around the mean without significant outliers. Some would refer to this as trading without an edge because the better odds usually “reside” around these outliers.
Risk assessment is the starting point for every trade
Most traders skip risk assessment and never look beyond entry timing. Before you enter a trade, you should compare the risk and return profile of the trade and evaluate whether it offers an asymmetric opportunity or not. In other words, does the trade set-up have an asymmetric profile where you have higher odds of success than failure. In that regard, you need to evaluate where you want to place your stop loss and where your profit target would go. Then you should compare the potential gain and the possible loss. If the win ratio is large enough, the trade could offer you an asymmetric return. However, this is just the starting point, and we will explore the next steps below.
Knowing the difference between your trades
Trade 1
- 25% chance of losing 10 points
- 25% chance of winning 10 points
versus
Trade 2
- 10% Chance of losing 10 points
- 35% chance of wining 10 points
You should always choose the second trade where the results are skewed in your favor. And even though that might seem like an automatic choice, the point is to get into a mindset where you evaluate and look to enter trades where losses are “contained”, but gains are significantly larger. Back testing your trades will give you the ability to see which trades can potentially give you better odds.
Setting Up Your Risk Management
You must exercise risk management. Without having a stop loss in place, a futures trader can neither determine his position size nor calculate the risk and return profile. It is just impossible to assess whether you have a decent asymmetric risk and return profile when you don’t use stop loss orders.
Disclaimer: The placement of contingent orders by you or broker, or trading advisor, such as a “stop-loss” or “stop-limit” order, will not necessarily limit your losses to the intended amounts, since market conditions may make it impossible to execute such orders.
Trade-off created by Asymmetry: Smaller winning trades or fewer trades
The trade-off many traders experience once they create trading opportunities with a larger reward to risk payout profile is that they either see a drop in their win rate or find less trading opportunities. This happens for numerous reasons.
The farther away the targets are on your trades, the harder it usually will become for the price to reach those levels. A trader will, thus, see more trades where price doesn’t reach his targets but rather “escapes” away from it. Or, he finds fewer trades once he starts filtering out the ones with a small reward to risk profile.
This is neither good nor bad. It is just the dynamics of trading playing out, and it is necessary that the trader is aware of it so that they are prepared once it starts happening. Keep in mind, most amateur traders focus on the higher percentage of winning rates as opposed to considering the size of loss when it occurs. This is in complete contrast to the idea of asymmetric trading.
Set the risk and return ratio in relation to your win rate
The size of the optimal risk and return profile depends on the success rate of your overall system. For example, a system with a win rate of 40% requires only a 1.5 profit to risk payout. This is just the minimum value required to trade to break even. You can calculate the ratio for yourself using this formula: [ (1 / winrate) – 1] ). The greater the asymmetric risk and return profile of the trade, the better the expectancy of such a system. It is therefore essential that you know the win rate of your system, calculate the minimum required risk and return ratio and then systematically try to get into trades where you have a significantly larger payout ratio. It is important that you stay reasonable with your order placement.
Performance Analysis 101
To make sure that you are moving in the right direction with your trading system, it is important that you regularly analyze your past trades.
Always compare the initial risk and return scenario that you planned during the entry with the outcome of the trade. As we said before, many traders are too optimistic when it comes to target setting and too conservative with their stops. Analyzing your past trades and comparing those can often provide valuable insights into how a trader can improve their system and increase the asymmetric risk and return ratio. After all, if you only balance risk with reward symmetrically, then you are unlikely to show any progress as a trader.
There is a substantial risk of loss in futures trading. Past performance is not indicative of future results.
