Win/Loss and Risk/Reward Ratios: How to Balance them
In your trading community, you might encounter individuals proudly proclaiming,
"I win in 90% of my trades!"
or others, confidently stating,
"I consistently risk $100 to gain $1000 on my trades."
While these declarations may initially seem impressive, it's essential to recognize that even with such seemingly favorable statistics, these traders may still be facing losses in actual dollar terms.
The challenge lies in the fact that both high win/loss ratios and enticing risk/reward ratios, when considered in isolation, don't offer a comprehensive view of profitability. Relying solely on either of these metrics as the foundation for your trading strategy may not lead to success in achieving your trading objectives.
This is precisely why understanding both terms and their interplay becomes crucial.
In the blog post below, we will try to understand the meanings of both win/loss ratios and risk/reward ratios, exploring how these terms work in tandem & what factors we must adhere to balance both.
What is a Win/Loss Ratio?
The win/loss ratio is a fundamental metric that measures the number of profitable trades (wins) versus losing trades (losses) over a specific period.
For example, a win/loss ratio of 2:1 means that for every two winning trades, there is one losing trade.
The win loss ratio can also be measured in percentage so a win loss ratio of 2:1 is equal to a 50% win percentage (1/2 x 100= 50% ) and ratio of 9:1 is 90% win percentage and so on.
These win percentages imply that the trader's winning trades outweigh their losing trades, POTENTIALLY indicating a successful approach to trading,
The Problem with Win/Loss Ratios
At first glance, Traders who consistently win 90% of their trades may understandably feel that they're on the right track. However, the issue with a high win/loss ratio lies in its potential to mask the real challenges of trading.
Consider a trader who boasts a remarkable 90% win rate, Each winning trade yielding $100 in gains. However,what if , when this trader does incur a loss, if a substantial one, resulting in, for example, a $1,000 deficit?. Despite the overwhelming success rate, the loss of $1,000 greatly outweighs the cumulative gains from those numerous winning trades.
As a result, despite achieving an impressive win rate, this trader finds himself in the red. The net result is a loss of $100. This reveals a crucial lesson for traders:
“It's not just about winning more often; it's also about managing losses effectively”
And how to manage this loss, the answer is
You see, It's not sufficient to focus solely on winning trades. It's equally, if not more, crucial to limit the impact of losing trades. Risk management strategies, such as setting stop-loss orders, position sizing, and having a well-defined trading plan, are essential for mitigating the financial hit from losses.
To counteract these challenges, traders often turn to another critical metric
The Risk/Reward Ratio:
“Greater the risk, greater the reward” is a fundamental principle of trading &
The risk/reward ratio is exactly like that. The ratio shows how much risk you are willing to take to achieve the desired profits.
The risk/reward ratio measures the potential profit against potential loss in a trade. It helps traders assess the balance between potential gains and losses before entering a trade. A higher ratio indicates a more favorable risk-to-reward profile, while lower ratios may increase the likelihood of losses outweighing profits.
For instance, a 1:2 ratio implies aiming for a $2 return by risking $1. Likewise, a 1:10 ratio strives for a $10 return with a $1 risk.
It's intriguing, isn't it?
The prospect of gaining $10 for every $1 risked is certainly appealing.
So, why doesn't every trader pursue this ratio?
This is where the plot thickens!
The problem with Risk/Reward ratios:
You will notice that when you keep increasing the desired profit levels in a risk/reward ratio, the likelihood of reaching those levels decreases. In simpler terms, aiming for higher profits comes with lower probabilities of success. It’s because the risks associated with achieving those ambitious profit targets also increase.
For instance, a 1:2 risk/reward ratio (risking $1 to make $2) has a higher chance of being attained compared to a 1:10 risk/reward ratio (risking $1 to make $10). The lower the risk/reward ratio, the higher the probability of success, but it comes at the expense of a lower reward.
Conversely, a higher risk/reward ratio offers a potentially more significant reward, but the likelihood of achieving it diminishes, making it a riskier proposition.
This interrelation between risks and rewards prompts us to strike a balance between approaches and brings us to another interesting aspect of the two ratios;
Also read: The Top 5 Criteria you can’t miss in your stock Scanner !
The Inverse Relationship between risk/reward ratios and win/loss ratios:
The inverse relationship of risk/reward ratios and win/loss ratios comes into play very often, because a trader often faces a trade-off between these two ratios.
The potential gains may be smaller when aiming for a high Win/Loss Ratio with tight stop-loss levels because such an approach involves cutting losses quickly to achieve a higher percentage of winning trades. In this scenario, the emphasis is on minimizing losses rather than letting profitable trades run for an extended period. Tight stop-loss levels restrict the upside potential, as the trade is closed at a relatively small profit rather than allowing it to reach a more substantial gain.
Conversely, if a trader opts for a high Risk/Reward Ratio by placing wider stop-loss levels, the potential gains may be larger. However, this comes at the expense of a lower Win/Loss Ratio because wider stop-loss levels mean the trade has more room to fluctuate, making it less likely to hit the profit target. While profitable trades may yield higher returns, the frequency of hitting profit targets decreases, resulting in a lower percentage of winning trades.
And over and above this inverse relationship, there is a catch !
Even, If you're able to manage positive Risk/Reward and positive Win/Loss, it's great, yet your profitability isn't granted yet,
since there is another important component
“Consistency”
If your Risk/Reward and Win/Loss are in the green but once in a while you break it with big losses, it means that you need to improve consistency. However, if you nail consistency as well, your profits are in the correct direction.
At AfterPullback, we combine these three parameters into the RCA framework, which is used to detect and generate;
R - Risk (=Risk/Reward),
C - Consistency, and
A - Accuracy (=Win/Loss).
And how do we do it? By embedding our RCA Framework in our AI trading Signals. This ingenious method, helps you to focus on opportunities with a higher Success rate.
How to be Profitable with Low Win/Loss Ratio & High Risk/Reward
Successful traders who consistently achieve profitability with a low win/loss ratio often employ a strategic approach to their strategy.
This strategy revolves around a fundamental principle:
Aiming to win big when they're right and being content with smaller losses when they're wrong.
Let's understand it with an example;
Consider a trader with Win/Loss Ratio of 30% & Risk/Reward Ratio of 1:5. The trader is looking for a stock with Share Price of $100. With a $100 share price, the stop-loss is set at $99 per share to limit the potential loss to $1 per share.
If The trader is correct in only 30% of their trades, meaning, Out of 10 trades, they win on 3 and lose on 7,
Then their Profit and Loss is calculated as follows;
Winning Trades (3 trades):
3 trades x $5 (reward for each share) = $15 profit
Losing Trades (7 trades):
7 trades x $1 (amount risked for each share) = $7 loss
Net Result:
$15 (profit from winning trades) - $7 (loss from losing trades) = $8 net profit
The example shows that
Profitability is possible even with low accuracy, If you set your risk/reward ratio slightly higher but the achievability of this higher risk/reward target should be substantiated by proper reasoning like historical trends.
Rather than trying to win every trade, this approach emphasizes capitalizing on the right trades
How to achieve Profitability with High Win/Loss Ratio and low Risk/Reward?
The Accuracy was on the lower side in the previous example, what if traders can predict their trades with more accuracy?
If this is the case, it can give a trader room to reduce their risk and reward ratio and achieve profitability.
Successful traders who prioritize a high win/loss ratio over large profits adopt this strategic approach. This strategy revolves around the concept of aiming for a high win rate while accepting less substantial profits.
Let's consider another trader with Win/Loss Ratio of 70% & Risk/Reward Ratio of 1:2. He is considering to buy shares of a company at a Share Price of $100
The trader risks $1 per share on each trade. With a $100 share price, the stop-loss is set at $99 per share to limit the potential loss to $1 per share.
The trader is correct in 70% of their trades. Out of 10 trades, they win on 7 and lose on 3.
Here is how the Profit and Loss on his trades will be Calculated:
Winning Trades (7 trades):
7 trades x $2 (reward for each share) = $14 profit
Losing Trades (3 trades):
3 trades x $1 (amount risked for each share) = $3 loss
Net Result:
$14 (profit from winning trades) - $3 (loss from losing trades) = $11 net profit
The example shows that
Profitability is possible even with low risk/reward ratio, If you are confident on the accuracy of your results , but the achievability of this higher accuracy should be substantiated by proper reasoning like Technical Analysis and historical trends.
Handling Unrealistic Risk/Reward Ratios
Setting excessively high risk/reward ratios can lead to unmet profit expectations. For example, a trader who establishes a 1:10 risk/reward ratio will aim for a $1,000 profit while risking $100.
But what If the market history shows that such profit levels are rarely achieved?
In that case, the trader will continue to incur smaller losses even if the stop loss level is set too tight and will never achieve that one-off trade which will put him to profit.
In that case, the trader must adapt to change. For example, he may adjust the risk/reward ratio to 1:3, with a $100 risk for a $300 profit target. This revised ratio will be more attainable and will be more aligned with historical data.
Also Read : Why Proper Trading Strategy Management Is Essential For Long-Term Success
How to maintain a balance between the risk /reward ratio and win/loss ratio?
As you might have noticed by now, achieving a balance between these ratios is crucial for a successful journey. However, achieving this balance is dependent on individual choices, one's own risk appetite, market conditions, and the ability to adapt to ever-changing circumstances.
Striking the right equilibrium between the Win/Loss Ratio and Risk/Reward Ratio necessitates continuous self-assessment, a commitment to learning, and the flexibility to adjust strategies in response to evolving market dynamics. Ultimately, successful trading is not a one-size-fits-all endeavor; it's a personalized journey that requires a thoughtful blend of analysis, discipline, and adaptability.
Below we have discussed the main factors that should be considered while forming your own strategies around the risk/reward and the win/loss ratios;
1. Define Clear Trading Goals:
Establish clear goals for your trading journey. Understand your risk tolerance, financial objectives, and the level of return you aim to achieve. This clarity will guide the development of your trading strategy.
2. Understand the Market Conditions:
Different market conditions may favor specific strategies. Be adaptable and choose a strategy that aligns with the current market environment. A strategy that works well in a trending market may need adjustments in a range-bound market.
3. Risk Management is Paramount:
Prioritize risk management. Set stop-loss levels based on your risk tolerance and the volatility of the market. Ensure that potential losses are controlled, even if it means sacrificing some potential gains.
4. Diversify Your Portfolio:
Avoid overconcentration on a single asset or market.
This becomes extremely important if your trading strategy is based on longer timeframes, such as weeks, months, and years.
Diversifying your portfolio helps spread risk and can contribute to a more balanced overall performance.
5. Focus on One Strategy:
Although considering combining strategies that complement each other may seem a good idea to certain traders, the reality is that Focusing on one strategy yields better results for most traders. It not only results in the efficient utilization of resources like Time, capital, and attention but also avoids potential conflicts and complexities of combined strategies.
6. Periodic Evaluation and Adjustment:
Regularly evaluate the performance of your trading strategy. If necessary, make adjustments based on changing market conditions, personal goals, or lessons learned from past trades.
7. Set Realistic Expectations:
Have realistic expectations about both the Win/Loss Ratio and Risk/Reward Ratio. Striving for an excessively high Win/Loss Ratio may lead to overtrading, while chasing an overly ambitious Risk/Reward Ratio may expose you to unnecessary risks.
8. Psychological Preparedness:
Develop mental resilience. Acknowledge that losses are a part of trading, and focus on the overall profitability of your strategy rather than individual trades.
AfterPullback's tools, such as AI backtesting allows you to fine-tune your trading strategy with pre-defined and consistent conditions and with Automated AI Trading signals you can execute these trades . This helps you to focus on the strategy and overcome psychological barriers by avoiding emotional decision-making based on short-term outcomes.
9. Backtesting and Simulations:
Before implementing a strategy, conduct thorough backtesting and simulations to assess its historical performance. This helps you understand how the strategy would have performed under various market conditions.
In conclusion, managing the delicate dance between Win/Loss and Risk/Reward Ratios is fundamental to achieving sustained success in trading. The quest for balance involves navigating the trade-offs, understanding individual risk tolerance, and staying attuned to the ever-evolving market conditions.
By recognizing that these ratios are interconnected and learning to strike the right balance, traders can make informed decisions, mitigate risks, and ultimately enhance the overall profitability of their trading journey
Trade Smarter!
