The Biggest Edge in Spread Betting
On the surface of things, trading looks incredibly difficult.
Dig a little deeper and you realise that the mechanics of being a profitable trader are outstandingly simple.
Dig even deeper and you experience that trading is bloody difficult again.
Why is this?
In short, it's because as humans we find it hard to be disciplined.
This is the most all-encompassing way to sum up the psychological frailties that we humans face when it comes to excelling in the markets. I'm not going to get bogged down in exploring this topic too much in this blog, but I do want to focus on why the mechanics of being a profitable trader are actually outstandingly simple.
What Are Edges in Trading?
I alluded to this in a recent post about the perils of system hopping in spread betting.
Examples of edges in trading are:
Positive risk-reward ratio
Trading with the trend
Trading around areas of support and resistance where you can get the best RRR (Risk Reward Ratio)
Averaging into trades to maximise winners on pullbacks or breakouts.
Being long on equities
Being a robot to ensure consistency and never missing a profitable signal for your system.
I could go into glorious detail on all of these topics, and I probably will soon. However, the one I want to delve into deeper for the purpose of this blog is number 1 in the list.
Risk Management: Positive Risk-Reward Ratio
The biggest edge in spread bet trading, without any doubt is risk management. In particular having a risk-reward ratio that allows for bigger winners than losers.
Why is this such an effective edge in the markets then?
Let's meet a few trader profiles, all of these guys start trading with a small balance of £1,000
Meet Trader A ('A' for "Ain't got a clue")
Trader A has zero financial education or knowledge of how to trade. They're totally guessing what happens on the charts.
So in order to choose a trade direction they flip a coin, why not? Heads - go long. Tails - go short.
Remember they have zero understanding of how to trade, therefore no risk management or trading plan whatsoever.
The coin comes up 'heads' - Trader A goes long. Betting £1 per pip stake.
The market goes up - and they sell quite quickly because they get excited and believe that you can't possibly go wrong banking profits. This is an assumption, but one based on a very common, and natural human instinct, and something commonly seen in beginner traders.
So trader A books a £10 profit.
The market goes down - but because their trade was initially to buy they end up holding on believing it will turn around, or should I say "hoping" that it will turn around. Without a plan, 'hope' is all poor old Trader A has.
The markets continues downwards and their PnL is currently at -£20.
Trader A is upset of course, slightly nervous that they'd made the wrong decision. But being a human, naturally, they don't wish to be wrong, and the moment they close the trade that's exactly what they'll be...wrong! The'll have banked a loss and got it wrong - horrible prospect for Trader A.
So they hold on until it turns around. After all, it can't go down forever.
It pushes down further and faster and now Trader A is feverishly watching every tick of the charts, their PnL reads -£100 now.
To close the trade now would mean Trader A is even more wrong than before and it'd be a painful loss to take.
At this point Trader A resolves to NOT close the position yet, but instead just give up all hopes of a profit and be 'sensible'.
"If I can just wait for this trade to reach break even again, then I'll close the trade for £0 profit, that's what I'll do". - Trader A (moments before shitting the bed)
... roll on the evening, and now poor old Trader A is tearing their hair out, angry at everyone around them (but mainly themselves), the PnL tells the tale of a trader with no plan and above all, no risk management.
-£500 (HALF THEIR ACCOUNT)
Trader A can take it no longer, and nervously closes the trade for a crippling 50% loss.
To add insult to injury, immediately after the trade was closed the price shot back up again and Trader A would have made a profit of £100.
Without a plan Trader A never had any chance of succeeding in the long run.
Even if they hadn't only banked small profits, but also got greedy and held onto profits for too long and never closed in the hopes that they'd always get more.
Whatever the outcome, that one big losing trade was always just around the corner waiting to wipe Trader A's account out.
It's a game of click and hope that is massively favouring the broker.
Meet Trader B ('B' for "Better than Trader A")
Trader B also has zero financial education or knowledge of how to trade. They too are totally guessing what happens on the charts.
However, Trader B love maths and understands that although they know nothing about trading they do understand risk-reward ratios. So to tilt the odds in their favour they're going to risk £10 if they lose, and they will take a profit if the price reaches a £30 profit.
This is a 1:3 risk-reward ratio (£10 risk : £30 reward = 1:3) - quick maths!
They agree that they'll do this every single time that they place a trade regardless of any other factors.
Trader B flips a coin, and like Trader A it lands on heads, so Trader B places the same size bet.
The market goes up - and they hit their profit target, banking £30 or 3% profit on their starting account size of £1,000.
The market goes down - and they hit their stop loss target, closing for a -£10 loss or -1% on their starting account size of £1,000.
Statistically we can say that their decision will be right 50% of the time if flipping a coin. The markets will either move up, or down, or sideways and then ultimately up or down.
However, with risk and reward both fixed this is an example of how somebody with zero knowledge can find an edge in the markets.
Sure they'll lose more often than they'd win, because the price only has to move 10 pips before they close their trade for a loss. But when it moves in the right direction 3x more (30 pips) they make 3x as much profit than they'd lose if they hit their stop loss to close the trade.
Similarly, if a Trader took a trade risking £10 and targeting a reward of £10 and flipped a coin then they'd have a 50% chance of getting the direction right with the coin flip, but also they'd lose as much as they gain half the time, so they'd break even over time, right? Statistically yes, but not in reality.
Were it not for one small factor, much like with roulette having the '0' in play if betting on red or black, trading has it's equivalent in the form of the spread for spread bet providers and commission for other traditional brokers and derivatives platforms. This means that from the moment you enter the trade you're at a disadvantage, and making a loss.
So this tells us that we must have an edge in the market to make money, you cannot take your chances and hope you get lucky, because in the end variance and probabilty will eat your money for dinner.
Here's a little graphic from Tradeciety which demonstrates the sweet spot with risk management and how it relates to win rate. I.e. the percentage of trades you win.
The Risk Game
Here's a little game I first saw on a Michael Covel's website Trendfollowing.com, that perfectly demonstrates how Trader B's risk principles work in a very visual and memorable way. This is taken from a course I put together for beginners on how to swing trade, you can find this course on the home page.
Check out the video below, I've got it set to start at the right point in the video.
Hopefully that has demonstrated how the very basics of risk management can give you an edge with your trading. Feel free to try this game yourself, it goes without saying that the more trades you take, or the more rolls of the dice using this strategy, the higher the correlation of positive results.
Now imagine how your spread betting strategy could improve and take shape as you add more edges into your trading. Revisit those 6 edges that I listed at the top of this post and incorporate this into your stratgy and you'll be taking the right path towards achieving profitablity.
Like I said right at the start of this post, it all boils down to discipline. You might tell Trader A all about risk management, but there's still nothing to guarantee that they'd stick to the rules, the human brain in a funny thing, our emotions run wild and can lead us to abandom all logic.
This is why 90% of retail traders lose money.
Profitable risk-reward ratio is the one edge that there's no excuse to exclude from any trading strategy.