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

Risk-reward ratio and win-rate how to use these indicators correctly

Derive benefits from every executed trade. Find a balance between the indicator of profitable trades and relation between the risk and yield.

If you are an intraday trader, do not aim only at a big number of profitable trades but also at their quality.

It might seem that if you execute 70% of profitable trades, it will make you a profitable trader but it is not quite so. It is also necessary for traders to assess the quality of their profits and losses. It is extremely important to find a balance between the indicator of profitable trades (win-rate) and correlation between risk and profitability (risk-reward ratio).

In this article:

  • Relation of profitable trades to loss-making ones.
  • Risk-reward ratio.
  • Finding a balance between the indicators.
  • Trading with optimal indicators of efficiency.
  • Calculator of the correlation between risk and profitability.

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Relation of profitable trades to loss-making ones

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.

Risk-reward ratio

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.

Finding a balance between the indicators

Intraday traders should find the happy mean between the win-rate and risk-reward ratio. A high win-rate doesn’t mean anything if the risk-reward ratio is very high and an excellent risk-reward ratio doesn’t mean anything if the win-rate is low.

Keep in mind the following rules when you develop an intraday strategy or improve results of your trading:

  • A higher indicator of profitable trades means that your risk-reward ratio could be higher. Your trading strategy would be profitable if the win-rate is 60% and risk-reward ratio is 1.0. And you will make even more with the win-rate of 60% and the risk-reward ratio below 1.0.
  • The low win-rate – 50% and below – assumes that, for profitable trading, trades should bring more profit compared to losses. Nevertheless, you could stay profitable even with the win-rate of 40% if the risk-reward ratio is below 0.6 (with no regard to commissions). Ideally, if your win-rate is below 50%, try to establish the risk-reward ratio below 0.65, decreasing this value as far as the win-rate goes down. The more you lose in loss-making trades, the more you should win in profit-making trades.

Trading with optimal indicators of efficiency

Since intraday traders trade every day under various trading conditions, many of them should develop a strategy which would allow them to execute from 50% to 70% of profitable trades.

However, it would become more and more difficult to achieve even an insignificant improvement of the win-rate outside the limits of the said range.

This win-rate provides a certain flexibility when selecting the risk-reward ratio. Try to make a bit more in profit-making trades than to lose in loss-making ones. If you risk USD 0.10, try to make at least USD 0.15. In this case the risk-reward ratio would be 0.67. Keeping this ratio below 1.0, there is a high probability that you will stay profitable with the win-rate of only 40% even if the trading day is not successful.

Your ideal correlation of quantitative and qualitative indicators would depend on your trading style. However, you do not need a very high win-rate or very low risk-reward ratio to become a successful trader. Find the happy mean and aim at stability.

Calculator of the correlation between risk and profitability

Enter values in the fields below and the calculator will produce the risk-reward ratio and the minimally required win-rate:

  • Calculation results:
  • Risk-reward ratio: 0.25
  • Required win-rate, %: 0.20

Calculation results:

  • Risk-reward ratio: 0.25
  • Required win-rate, %: 0.20

Created by uCalc calculator builder

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