This isn't brain surgery here. A 1:1 risk/reward ratio assumes that your stop is equal to your profit target. 1:1 If you take profits early but let your losses run to the stop, you are are not trading the system and you'll skew your results. If your 'edge' in the system is a 60-65% win ratio based on 1:1, but you are taking profits in a discretionary manner, then you are not trading the 'system', and your win ratio will change accordingly. For example, you may go to a win ratio of 70% by pulling trades early, but your risk/reward will then skew to the negative, putting you at even or an overall loss. You may have heard the saying "You'll never go broke taking profits." That's untrue. Taking your profits early may feel good, but your losses will eat you up when your risk/reward ratio starts skewing the wrong way.
How can you assume your ratio will skew to the negative?? Assuming there's just a normal distribution, your increased win rate should offset the bigger losses, right? It's all the same, I make $1 50% of the time or $2 25% of the time.
I know what you are getting at but the point is that (as you stated) you have already backtested and discovered the (historical) optimum profit target. By trading at all you are implicitly saying that you do not think that stock movements are random and "normal" or any other regular distribution. If it were, you couldn't make money - it'd be the classic 50/50 coin flip. If you have an edge and it is well defined enough that you believe that there is a robust optimal profit target, and all your money mngt, risk mngt, etc is based on shooting for it, then any alternative exit point will be inferior and, with enough tweaking, eventually send your returns b/e or negative.
You're ignoring the fact that your stop loss remains the same. You need to develop your system in a backtesting environment and view the results yourself.
What I'm confused about is this: if you get out earlier, your increased win ratio should offset the extra money you're losing when you're wrong. So it's the same as far as I can tell. You are absolutely right. That's why thinking about ratios these or those is a waste of energy. STICKING TO THE RULES IS WHAT TRULY MATTERS. You know the "ratios" only in hindsight.
That makes sense. I guess I understand mathematically how scaling out could be worse than break even against all-out. For example, if my target is $1 and my backtesting shows that the target is hit 65% of the time with a $1 stop, that does not automatically mean that the same edge exists proportionally on prices before the target. While it may be true that you're not giving anything away by getting out of a portion earlier, if you haven't backtested that portion and incorporated it into your strategy, there is no way of knowing if getting out early is worse or not.
This thread got me to thinking about a couple more things regarding risk/reward and I was hoping someone could shed some light, especially those of you who have answered some of my questions already, I really value your feedback. I am having trouble understanding exactly why successful traders usually advocate a reward-to-risk where the reward is several times the risk (i.e. 4 to 1, 5 to 1, etc). Obviously I understand that it makes logical sense for your winners to be much larger than your losers and it goes along with a few important psychological mantras in trading (cut your losses short, let your profits run) and if something is hard to do psychologically it is generally correct. But why exactly is it more profitable to trade this way then something like my strategy, which advocates a higher win ratio? Is there some sort of self-preserving mechanism in the market that makes it more profitable to trade a 4 to 1 r/r with a 30% win ratio than a 2 to 1 with a 50%? (these are the same EV). And if you have a choice between both of these strategies , shouldn't you always take the 2 to 1 for a smoother equity curve? There must be some things I just don't understand because every trading book I read condones the use of a high multiple r/r, yet if you are meticulously following a strategy, it seems more optimal to trade something where you are correct more often. That in and of itself is interesting because is goes against yet another psychological mantra that you shouldn't feel the need to be right all the time. Thoughts appreciated! I know this is really basic stuff for many of you.
Over 1 year forward testing, I have a 60% win ratio proven with brokerage statements. Profit and stop are around 1 to 1. However, once in a blue moon I may let a few contracts run a little longer to increase profit while closing out most of them. Also, sometimes I may dollar cost down instead of taking a stop.