Risk Reward Ratio + Win Ratio: They are teaching you WRONG
Your win rate is how many trades you win out of all your trades.
A risk reward ratio is how much you expect to make on a trade, relative to how much you’re willing to lose.
Right? Briefly.
It makes sense to believe that if you win more trades than you lose, you’d be turning a profit with your trading strategy. However, winning trades doesn’t always equal profit at the end of the day.
To understand the importance of Risk Reward Ration (RRR), if your winrate is 70%, each 10 trades you win 7, but your few losers are so big they can wipe out your winners.
On the other hand, if you have great Risk Reward Ration (RRR) per trade, let’s say 1:3 but your winning rate is only 20% so out of 10 trades you have 8 losing trades and 2 winners.
Total Loss: $1 * 8 = -$8
Total Gain: $2 * 3 = $6
Net loss: -$2
You need to create a balance between your win-rate and risk-reward ratios, which is crucial to success as a day trader. So how to combine your risk-reward ratio with your winning rate to know whether you’ll make money in the long run? Expectancy.
Assuming you keep records of your trades, you should go back and look at all your trades that were profitable versus all your losing trades. Do this over a period of at least 3 months or at least 100 trades. The more data you can use, the more accurate the result. We only need 4 pieces of information: number of winning trades, number of losing trades, size of money won and size of money lost. From this data we can calculate:
Net Profit = Amount of money won-amount of money lost
Win Rate = Number of winning trades / total number of trades
Lose Rate = 1-win rate
Average Winner = amount of money won / total number winners
Average Loser = amount of money lost / total numbers of losers
Average Reward Risk Ratio (RRR)= average winner / average loser
Expectancy per trade = (win rate x average winner)-(lose rate x average loser)
Expectancy per amount of money risked = win rate x (average RRR+1) -1
Ilustrating this with an example, let’s assume we have been trading 3 months and made total of 150 trades. 99 of them were profitable, 51 were not, with $55,505 profit from wining trades and $20,400 loss.
Net Profit: 55,505–20,400 = $35,105
Win rate = 99 / 150 = 66%
Lose rate = 1–66% = 34%
Average Winner = 55,505 / 99 = $560.65
Average Loser = 20,400 / 51 = $400
Average RRR = 560.65 / 400 = 1.40
Expectancy per trade = (66% x 560.65)-(34%x400) = $234,02
Expectancy per $ risked = 66% x (1.40 + 1)-1 = 0.58
That means the trading strategy will return 38 cents per dollar risked.
