Newbies focus on win percentage, educated traders focus on Risk/Reward Ratio, veteran traders focus on win percentage and Risk/Reward together
If I had a strategy that has a win percentage over 90%, would you be willing to use it? If you quickly responded, “yes,” you should think a bit longer about what a 90% win rate actually means. On average, my strategy will win 9 times out of 10, but how does this translate into actual dollars and cents?
Win percentage on its own does not create a winning strategy. We also need to know how much the strategy is winning and losing on the average trade to determine if it has an edge.
Our profit per trade is tiny compared to the loss we take when we are wrong. So all those profitable trades are completely offset by the rare but large losing trades. We would actually need a win rate greater than 98% to be profitable using this strategy, something nearly impossible.
Focusing on the Risk:Reward Ratio
Once traders realize that a high win rate won’t guarantee that their
strategy will be profitable, they often turn to creating a strategy
using a positive risk:reward ratio. A positive risk:reward ratio
means that we set our profit target further than we set our stop loss.
So our reward is greater than or potential risk on each trade.
Most Traders Use a Negative Risk:Reward ratio:
The key benefit to using a positive risk:reward ratio is that it takes
pressure off of our strategy’s win rate. We know that as
long as we are correct at least 50% of the time, we should be
profitable. In fact, our win rate doesn’t need to be that high. We can
make money with a win rate much lower than 50% if our risk:reward ratio
is strong enough.
Combining Win Rate and Risk:Reward Ratio
We need to have an edge when we take into account our win rate
AND our risk:reward ratio. Neither attribute can make us profitable on
their own. The chart below shows several risk:reward ratios and the win
rate required to produce breakeven results. To be profitable, we need to
have a win rate higher than the breakeven win rate next our preferred
risk:reward ratio.
Risk: Reward Ratio and It’s Breakeven Win Rate Require":
