What is a profitable trading system?

Throughout interaction with many clients over the years, some of the most common questions we receive are:

1. What is the winning rate of your trading signal?

2. How many pips does the signal produce per month?

3. How often do you send your trading signal?

In this article, we will try to define what a profitable system looks like and also answer the questions above.

Truth #1: A Profitable Trading System does not not always depend on high winning rate

There’s a trade off between winning rate and reward vs risk ratio (R:R ratio). A trading system with high winning rate of 80-90% typically takes profit very quickly, maybe on average 10-25 pips profit. However, in this type of trading system, the trade off is a low R:R ratio. So typically the R:R on this type of system is 1 to 1 or less. Imagine a trading system that takes a 10 pips quick profit with a hard stop loss of 5 pips. How hard will that be? It’s almost impossible not to get stopped out many times with just 5 pips stop loss!

Thus there are two extreme ends when it comes to trading system. On the one end, we have a trading system with high winning rate and poor risk to reward ratio. This type of system can still be profitable but it relies heavily on the high winning rate. Of course it still has to have stop loss, position sizing, and risk management to achieve profitability. Now a trading system might have high winning rate of 90%+ because it takes profit very quickly, but if the system comes without any clear rule to limit losses, then basically a 90% winning rate means nothing. It just takes 1 bad trade in this case to completely wipe out all the profit or even blow out the trading account. A trading system which allows losses to keep accumulating without stop loss won’t last long.

So, in conclusion, a high winning rate trading system does not always mean a profitable trading system. It can be profitable as long as there’s a risk management rule on the system, but the reward vs risk is low and it relies heavily on high winning rate. The market’s condition and behavior however rarely stays the same all the time, so in general it’s not easy to maintain the same high winning rate month-after-month and year-after-year.

On the other end of the spectrum, there’s a trading system with low winning rate such as 45% –" 55%, but the reward vs risk (R:R ratio) is at least 2 to 1. A system which has 2 to1 Reward vs Risk is profitable even if it only wins 50% of the time. Imagine if a trader risks 1% in each trade and trades 10 times. Let’s say the winning rate is 50% and Reward vs Risk is always 2 to 1. Each loss will result in -1%, and each win +2%. Thus if a trader trades 10 times, the total is (5×2%)-(5×1%) = 5% profit.

A trading system with high reward vs risk ratio does not rely on high winning ratio to be profitable. It only needs to win 45-50% of the time and still be profitable. Thus instead of asking about the winning rate of the trading system, the better question is just to simply ask: Is your trading system profitable in the long rum?

Truth #2: A Profitable Trading System does not necessarily produce high number of pips

Imagine the following scenario: Trader A makes the first trade in $EURUSD with 50 pips stop loss and 100 pips target. In this trade, trader A risks 1%. Let’s say trader A wins this trade, then since the target of 100 pips is 2 times of the risk of 50 pips, that means trader A makes 2% profit. If you focus on the number of pips, then in this case, trader A makes 100 pips profit. Now trader A makes another trade. In the second trade, trader A makes another trade in $EURUSD with 20 pips stop loss and 40 pips target. Let’s assume trader A risks 5% on the second trade and loses this trade, so trader A loses 5%.

To summarize the two trades from trader A:

Trade #1: +2% and trade #2: -5% for a total of -3%. In terms of pips however,

Trade #1: 100 pips, Trade #2: -20 pips, so in total is +80 pips.

You can see from the illustration above that in these two trades, trader A loses 3% even though on paper he/she is positive 80 pips.

In contrary, imagine another scenario in which trader B makes the first trade in $EURUSD with 20 pips stop loss and 40 pips target and risks 5%. Let’s assume trader B wins this first trade, so trader B wins 10% because the reward vs risk is 2 to 1. Now imagine trader B makes the second trade in $EURUSD with 50 pips stop loss and 100 pips target and risks 1%. Let’s assume trader B loses the second trade, so that means trader B loses 1%.

To summarize the two trades from trader B:

Trade #1: +10% and trade $2: -1% for a total of +9%. In terms of pips however

Trade #1: +40 pips and trade #2: -50 pips for a total of -10 pips.

Thus, in these two trades, trader B is negative 10 pips in total but positive 9% in profit.

As you can see above, the number of pips won doesn’t guarantee profitability. A better question to ask therefore is just to simply ask: Is your trading system profitable in the long run?

Truth #3: A Profitable Trading System does not depend on how frequent signals are given

New traders are always getting overly excited and want to trade every time. It’s similar to gambling, sometimes it can cause addiction. A reliable and solid trading system however must have very clear rules. At minimum, a complete trading system should include rules such as condition when and where to enter trade, where to put stop loss, and where to take profit.

Trading should be a very simple process. If the conditions satisfy the rules of the system, we trade. If there’s no condition that satisfy the rules, it doesn’t matter what the market does, it doesn’t matter what the Elliott Wave chart shows, then it’s a no trade. We always say that everyday is a working day as we need to follow the market to understand the cycle, but not everyday is a trading day.

We also believe that we should take what the market gives, regardless of the instrument. The more instrument we trade, the more opportunities there will be to trade. If a trader focuses only on trading $EURUSD, there might not be setups for weeks and months if the market is sideways or if it doesn’t satisfy the rules of entry in the trading system. That’s why we cover 72 instrument and scan the market to see if the condition to trade exists in any of the instrument we cover. We will trade whatever the market gives when conditions exist to trade that instrument.

Our Trading System at EWF

In addition to providing Elliott Wave chart updates, we also have our own trading system with very clear rules. The system is based on Elliott Wave, but there’s certain conditions that have to be present in order for us to take trades. Thus, not every single update in Elliott Wave chart is something that we like to trade at EWF.