What are you taking into consideration when you evaluate your trading session? Some traders tend to look only at the percentage of the winning trades. But more wins than losses do not necessarily mean, you end up with a profit.
One more component to take into account is the quality of your gains and losses. And here you have a win/loss ratio and risk/reward ratio, as well as acceptable risks and losses. You should pursue a balance between a win/loss and risk/reward ratio.
Many traders aim at having most of their trades winning. But the truth is that even when almost all transactions earn profits, it does not guarantee success.
Win/loss ratio or win rate tells you how many transactions from all your trades win. Let’s say you open 5 positions in a day. 3 of them earn profits. The win rate is 60% (3 out of 5). This is your daily win rate. You can also check your monthly win rate. Let’s take 100 trades where 60 end up winning. Your monthly win rate will be 60%.
You can calculate the win/loss ratio by dividing your wins by your losses. In the above example, the daily win/loss ratio is 3/2 which gives 1.5. And the monthly win/loss ratio will be also 1.5 as this is the result you get when you divide 60 by 40.
A desirable win/loss ratio is above 1.0, and the win rate higher than 50%. However, this is still not enough to increase capital balance in your account. If the amount you lose is greater than all your winnings, you will not end up with the profit. Therefore, you should also look at the risk/reward ratio.
As a trader, you must reflect on how much you wish to win and how much you are ready to lose. The relation of these two is called a risk/reward ratio.
Day traders often want fast profits so they enter short-term trades. When they set a stop loss, they determine at what loss the transaction will be closed automatically. On the other hand, they expect the price will go in the desired direction so they set a take profit at the predicted level. Let’s discuss it on the example.
You are buying a stock at $10. You are ready to lose $0.10 so you set a stop loss at the level of $9.90. You make the analysis and your prediction is that the price will hit $10.20 so you set a take profit at such level. This means that the possible risk is two times smaller than the possible reward. To calculate your risk/reward ratio you must divide a potential risk by the potential reward. $0.10/$0.20 is 0.5.
When you finish the trade with the profit $0.10, your risk/reward ratio will rise to 1.0 as both, the risk and reward, are $0.10. And if your profit is merely $0.05, the risk/reward ratio will be even higher as $$0.10/$0.05 = 2.
You should aim at low risk/reward ratio. Despite high risk tolerance, lower risk/reward ratio will help you to diminish losses and optimize the profits.
A balance between win rate and risk/reward ratio
In order to maximize profitability, you will have to search for a balance between win/loss and risk/reward ratio. It is not enough to work on one metric only. Even if your win rate is high, it will not bring you high returns, when your risk/reward ratio is quite high. And the opposite, even with low risk/reward ratio, you will not earn a lot when the win rate is too low.
How to find a balance? What are the sufficient win rate and risk/reward ratio?
- When your win rate is high, you can allow yourself for a bit higher risk/reward ratio. With the win rate at 60% and the risk/reward ratio at 1.0, you may still make a profit. Nonetheless, with a lower risk/reward ratio, your profits will be higher.
- When the win rate is pretty low, below 50%, you need a low risk/reward ratio too, because you will need your wins to be much bigger than the losses. So with the win rate around 40%, the risk/reward ratio ought to be below 0.6.
Calculate your win rate and risk/reward ratio. Find the balance and keep working to improve the metrics. Day traders open transactions every day in different markets and so in different conditions. As a day trader, you should design a strategy that will ensure 50% to 70% of winning transactions.
With the win rate above 50%, you are able to have a bit of flexibility in the risk/reward ratio. Naturally, make an effort to earn more on the winning trades than you lose on the losing ones. Try not to have a higher risk/reward ratio than 1.0. Ideally, your wins ought to be around 1.5 times bigger than the risk you are ready to take.
Your trading style also influences trading metrics. So practice different strategies and find your own equilibrium. Share your thoughts on this topic with us in the comments section. You will find it down below the site.
Wish you high profits!