The Importance Of The Risk Reward Ratio And Win Rates, And Why Most Retail Traders Get Them Wrong

What's the first thing new traders typically measure?

Measuring your success as a trader, and tracking your progress, is essential if you are to sustain successful trading over the long term. But how do you go about tracking your trading, and judging your results?

Most new traders typically measure themselves by their P+L, how much they made (or lost) over the trading day. But this metric doesn’t tell them much about how they performed throughout the day, and if the strategies they are pursuing will be successful over time.

There are lots of other metrics we can use to measure our performance, and below we are going to take a look at some of the key ones, and why some retail traders get them wrong…

In this post we will take a look at the following:

1. Win Rates in trading, and how to calculate them
2. The Risk-Reward ratio, and how to calculate it
3. Why new traders focus on these metrics
4. How professional traders combine them to produce Expectancy
5. How to calculate and use Expectancy
6. How to improve as a trader

What is the Win Rate metric in day trading?

Simply put, the Win Rate is the percentage of trades that are winners vs losers over the course of the trading day.

For example, if you make 10 trades in a day, 7 of which result in a net positive P+L, then your Win Rate for that day is 70%.

Many new traders focus on this metric, constantly trying to improve it, in the belief that if they can achieve a high number they will be a profitable trader. However, assuming that if you achieve a high Win Rate you will make money, can be dangerous.

What if your Win Rate is 70%, but the size of your losses, the amount you lose on each trade, far exceeds the amount you make when you have a winning trade?

If trader ‘A’ has a Win Rate of 70% and is making on average $100 on every winning trade, but losing on average $300 on their losing trades, then over the course of 10 trades the trader will return a negative P+L

(7 trades x $100) – (3 trades x $300) = -$200

This trader has a poor Risk Reward ratio, they are risking $300 to try to make $100.

What is the Risk-Reward ratio?

The Risk-Reward ratio measures the reward a trader can earn for every dollar they risk on a trade. Many traders use Risk Reward ratios to compare the expected returns of a trade with the amount of risk they must undertake to earn these returns.

A trader with a Risk-Reward ratio of 1:4 suggests that they are willing to risk $1 for the prospect of earning $4. Alternatively, a Risk-Reward ratio of 1:2 signals that a trader should expect to invest $1 for the prospect of earning $2 on their trade.

This Risk Reward ratio can be thought of in terms of placing a bet. A person might place a $10 bet on an outcome that would deliver a payout of $40 if they won. In trading terms, it’s opening a position in the market, placing a stop that would exit the position at a loss of $10 if the market goes against the trader, but yielding a profit of $40 if the market moves in the trader’s predicted direction. In these scenarios, both the bet and the trade have a Risk-Reward ratio of 1:4

How do you calculate the Risk-Reward ratio when you make a trade?

Traders typically define their Risk-Reward through their entry and exit points in a trade, and calculate it as follows:

(Entry – Stop loss) : (Take Profit – Entry )  

For example, Crude oil is trading $60 a barrel. Trader ‘A’ wants to go long at $60, with a stop at $59.90 (risk), and a profit target of $60.20 (reward)

(60-59.90) : (60.20-60)

=  10 ticks : 20 ticks

Or a risk/reward ratio of   1:2

What is a good Risk Reward ratio?

Many traders believe that just having a healthy Risk Reward ratio will mean they will be consistently profitable, but it’s not the case. And you will often read online that a trader needs a minimum of 1:2 as a ratio to be profitable, but this is also misleading.

Let’s take a look at why some traders think like this

Just like the Win Rate metric, the Risk-Reward ratio is ineffective when used on its own as a data point. Let’s take a look…

You are trading up a storm, you have a healthy ratio of 1:2, so for every dollar you risk you are earning two, and you are making plenty of trades throughout the day.  You should be making money, right? Well, what if only 30% of your trades are winning trades?

If you are risking $100 in order to make $200, over 10 trades the data looks like this:

3 x $200 = $600 profit on winners , less 7 x $100 on losses = -$100 (not including commission!)

So, what should your Risk Reward ratio be?

This is a difficult question to answer because it will all depend on where your Win Rate sits.

How professional traders view the Risk-Reward ratio

Professional traders do not look at the ratio in isolation, they combine it with the Win Rate to develop a solid strategy and start to get a measure of their Expectancy (more on Expectancy below).

As I said before, some traders believe you need a minimum of 1:2 to be successful, but if you have a very high win rate, then your Risk Reward can be lower. Conversely,  if your win rate is low then you need to make sure your ratio is much higher. Let’s have a look at a couple of examples:

Trader A has a win rate of 76%, but their Risk Reward is low at  1:0.8 .

If the trader risks on average $100 on every trade, then they are going to make $80 on the winners. Over 100 trades the data looks like this:

(Winning trades 76 x $80) – (losing trades 24 x 100) = 6080-2400 =+$3680

In another example, trader ‘B’ has a win rate of 40% but a ratio of 1 : 3, if they risk $100 on every trade, they are going to make $300 on the winners. Over 100 trades the data looks like this:

(Winning trades 40 x $300)- Losing trades 60 x $100)=12000-6000=+$6000

Mapping your Win Rate against your RR ratio will help you start to understand what your Expectancy is, and help you to understand where you might want to focus your improvement.

Pulling it all together - EXPECTANCY

Expectancy is the key metric that traders use to monitor their strategies, and it sits in the same family as the  Win Rate and Risk-Reward ratio.

The trading Expectancy metric shows what the typical profit is for each trade placed. If it’s a negative number, the strategy is a losing strategy, if it’s positive, the strategy is a winner.

Calculating  Expectancy

Expectancy is calculated as follows

(Win Rate x Average Win Size) – (Loss Rate x Average Loss Size)

Win rate % is converted to decimal, for example, a win rate of 76% is input as 0.76. Take a look at this example.

Trader A wins 20% of the time, but they make, on average, $1000 on their winners and lose on average $100 on their losers.

(0.2 x $1000) – (0.8 x $100) = $200 – $80 = $120

The number is positive, which shows the strategy has a positive expectancy and makes money.

What does the $120 represent? The Expectancy is the average return for each trade, including wins and losses. Therefore, trading Expectancy is what we expect to make on each trade, based on our Win Rate and average gains and losses.

What's the relationship between the Win Rate, the Risk-Reward Ratio, and Expectancy?

Unfortunately, just trying to improve on one of these in isolation often does not work. Most people find that if they are holding out for trades with bigger payoffs (to improve their Risk Reward Ratio) and not taking into consideration their Win Rate, then it may impact their Win Rate negatively.

We also often observe the opposite relationship – if a trader focuses on trying to improve just their Win Rate, then they may start to experience a slip in their Risk Reward ratio.

So how do I improve as a trader?

Firstly, it’s important to observe and map these metrics over time.

It takes time to build up a meaningful data set –  it’s far better to be calculating your Win Rate over 100 trades than it is over 10 trades. But, as you build your data and track it, you will start to see trends and patterns emerging, and start to get a real insight into your strengths and weaknesses.

Secondly, experiment, you may find that trying to improve your Win Rate has less of an effect on your Risk Reward, than trying to improve your Risk Reward has on your Win Rate (or the other way around!)

Thirdly, have the right expectations. If you already have a Win Rate in the 70’s it’s going to be difficult to improve that rate as it’s already high, you will need to focus on your Risk Reward ratio. Conversely, if you have a low win rate, you are going to need a higher Risk Reward to have a profitable strategy.

Finally, focus on Expectancy, watch how making adjustments to your trading impacts this number, and observe if this number is improving or degrading.

Summary

Over time you will start to develop a sense of your appetite for risk, and of where you are comfortable putting your stops (the exit point of your losing trades). From here you can start to look for trading opportunities that will yield a reward in line with your ratio.

The evolution of a trader takes time, and work. Post-trading day analysis and self-reflection are crucial to your growth.  Remember, when you have closed your last trade for the day, there is still work to be done if you want to improve!

Good luck with your trading.

James.