Risk-reward ratio and win-rate: how to use them correctly

A big number of intraday traders are oriented at the indicator of profitable trades (win-rate) or the ratio of relation of profitable trades to loss-making ones (win/loss ratio). Their final goal is in achievement of such a level of trading, at which all their trades would be profitable.

However, make no mistake that a high level of profitable trades doesn’t at all mean that you would be a successful or even profitable trader.

The win-rate is a number of profitable trades during a certain period of time in the general number of executed trades for the same period of time. For example, if you executed 5 trades during a day and 3 of them were profitable, your daily win-rate is calculated as 3/5=0.6 or 60%. If you had 20 trading days during a month and 60 out of 100 trades turned out to be profitable, your monthly win-rate would be 60%.

The win-loss ratio is calculated by dividing the general number of profitable trades into the general number of loss-making ones for a certain period of time. For example, you executed 100 trades during a month, of which 60 trades were profitable and 40 – loss-making. In this case, the win-loss ratio would be 60/40 = 1.5. It means that 50% of your trading time you execute more profit-making trades than loss-making ones. From the point of view of successful trading, the win-loss ratio above 1.0 or the win-rate above 50% are considered to be preferable but it is insufficient.

The risk-reward ratio shows what yield you expect to receive from a trade compared to how much you are ready to lose in a trade.

Intraday traders want to open and close trades in a speedy fashion, using advantages of short-term patterns and trading signals. As a rule, it means that a trader posts a stop loss when executing any trade. A stop loss identifies the risk size in cents, ticks or pips, which a trader can accept trading a stock, futures or currency pair.

Let’s assume you decided to risk USD 0.10 on XZYZ stock buying it at USD 10.00 and setting the stop loss at the level of USD 9.90.

Now your risk is fixed in the amount of USD 0.10 (in the event there is no slippage), but, at the same time, you should compensate the taken risk with a potential profit of the trade, since namely the goal indicator of the profit identifies the size of the expected reward.

Now let’s assume that you made a forecast, based on your market analysis or trading strategy signal, that the price would reach the level of USD 10.20, at which you would register profit in the result of which you would make USD 0.20.

Thus, your potential reward is twice as big as your potential risk. Your risk-reward ratio is USD 0.10 / USD 0.20 = 0.5. In other words, your risk is exactly a half of the potential profit of the trade.

If you register the p[rofit at the level of USD 10.10, your potential yield and risk in the trade would both be USD 0.10, which means that the risk-reward ratio would be USD 0.10 / USD 0.10 = 1.0. If you register the profit at USD 10.05, your potential risk would be USD 0.10 and the yield only USD 0.05. In this case, the risk-reward ratio grows to 2.0 sending you a signal that you risk more than make.