If you want to continue trading successfully in the long run, you must measure your trading success and monitor your growth. However, how can you monitor your trading and assess your performance?
The profit (P) + loss (L) equation throughout the trading day is usually how most novice traders gauge their own performance. However, this metric doesn’t provide them with any insight into their performance during the day or whether the tactics they are pursuing will pay off in the long run.
We’ll look at a few of the most important measures below, along with the reasons why some retail traders utilize them incorrectly. There are many more metrics we may use to assess our success.
What Is the Win Rate Measure for Day Trading?
Simply expressed, the win rate is the ratio of deals that generate profit versus losses over the trading day. For example, if you make ten transactions in a day and seven of them result in a net positive P+L, your win rate for the day is 70%.
Many new traders focus on this measure, continually striving to improve it, with the notion that achieving a high figure will make them a profitable trader. However, presuming that achieving a high win rate will result in financial success can be risky.
What if your success rate is 70%, but the size of your losses, or the amount you lose on each trade, significantly outweighs the amount you make when you win?
If trader ‘A’ has a 70% win rate and makes an average of $100 on winning trades but loses an average of $300 on losing transactions, they will have a negative P+L of -$200 over 10 deals. This trader has a bad risk-reward ratio; they are risking $300 to make $100.
What Is the Risk/Reward Ratio?
The risk-reward ratio calculates how much a trader can gain for every dollar they risk on a trade. Many traders utilize risk-reward ratios to compare the predicted rewards of a trade to the level of risk required to achieve these returns.
A trader with a risk-reward ratio of 1:4 indicates that they are prepared to risk $1 for the chance of earning $4. Alternatively, a risk-reward ratio of 1:2 indicates that a trader should expect to invest $1 in order to earn $2 on their bet.
This risk-reward ratio can be thought of as a gamble. A person might bet $10 on an outcome that would result in a $40 reward if they won. In trading terms, it entails opening a position in the market and placing a stop that will exit the position at a loss of $10 if the market moves against the trader but yields a profit of $40 if the market moves in the trader’s expected direction. In these cases, both the bet and the transaction have a risk-reward ratio of one to four.
What Is a Good Risk-Reward Ratio?
Many traders feel that simply maintaining a good risk-reward ratio guarantees they will be constantly profitable, but this is not the case. And you will frequently read online that a trader requires a minimum of 1:2 as a ratio to be lucrative, but this is also false.
The risk-reward ratio, like the win rate measure, is worthless as a standalone data point. You’re having a great day trading, with a healthy ratio of 1:2, which means you’re earning two dollars for every dollar you risk, and you’re making a lot of transactions. You should be making money, correct? What if you only win 30% of your trades?
If you risk $100 to make $200 in ten trades, the data looks like this:
3 × $200 = $600 profit on winners, less 7 x $100 on losses = $-100 (not including commission!)
The Perspective of Experienced Traders on the Risk-Reward Ratio
Expert traders use the ratio in conjunction with the win rate to create a strong trading strategy and begin calculating their expectancy. As previously said, there are traders who think that a minimum of 1:2 is necessary for success; nevertheless, if your win rate is extremely high, your risk-reward may be lower. On the other hand, you should ensure that your ratio is significantly larger if your win rate is low. Let us examine a handful of these instances:
Trader A’s win percentage is 76%, however, their risk to reward ratio is only 1:0.8.
The trader will profit $80 from winning trades if they risk, on average, $100 each time. The data from more than 100 deals looks like this:
(Trades won 76 x $80) – (Trades lost 24 x 100) = 6080 – 2400 = +$3680
In a different illustration, trader “B” has a 40% win rate and a 1:3 ratio. If they risk $100 on each transaction, they will profit $300 from the winners. The data from more than 100 deals looks like this:
(Trades won 40 x $300) – Trades lost 60 x $100) = 12000 – 6000 = +$6000
You can begin to grasp your expectancy and where you might want to focus your improvement by mapping your win rate against your risk-reward (RR) ratio.
Completing the Picture: Expectancy
The main indicator that traders use to keep an eye on their tactics is expectation, which is related to win rate and risk-reward ratio.
The trading expectancy measure displays the average profit on each trade that is executed. The strategy is winning if the number is positive; if it is negative, the technique is losing.
How to Compute Expectancy
The following formula is used to determine expectation:
(Average win size x win rate) − (Average loss size x loss rate)
The win rate percentage is expressed as a decimal; for instance, a 76% win rate would be entered as 0.76. For instance, trader A has a 20% winning percentage, however they lose $100 on average on their losses and make $1000 on average on their victories.
(0.8 x $100) – (0.2 x $1000) = $200 – $80 = $120.
The fact that the number is positive indicates that the strategy is profitable and has good expectation.
What does the sum of $120 mean? The average return on every deal, including profits and losses, is called the expectation. As a result, trading expectation refers to our expected profit or loss on each trade, which is determined by our win rate and average gains and losses.
What Connects Expectancy, the Win Rate, and the Risk-Reward Ratio?
Regretfully, it is frequently ineffective to strive to improve on one of these alone. The majority of people discover that hanging out for trades with larger payoffs (in an effort to increase their risk-reward ratio) without considering their win rate can have a detrimental effect on their win rate.
We also frequently see the opposite relationship: if a trader only concentrates on increasing their win rate, their risk-reward ratio may begin to decline.
How Can I Become a Better Trader?
First and foremost, it’s critical to track and record these indicators across time.
Building up a relevant data set takes time, so it’s preferable to calculate your win rate over 100 trades as opposed to 10 trades. However, as you accumulate and monitor your data, you will begin to notice patterns and trends that emerge, giving you a clear understanding of your advantages and disadvantages.
Second, give it a try. You might discover that attempting to raise your win rate has a greater impact on your risk-reward than it does on your win rate (or the opposite!).
Thirdly, set reasonable expectations. It will be challenging to raise a win rate in the 70s as it is already high; instead, you should concentrate on your risk-reward ratio. On the other hand, to have a lucrative strategy, you will require a greater risk-reward if your win rate is low.
Lastly, pay attention to expectancy. See how your trade tweaks affect this figure and note if it is rising or falling.
Conclusion
You will gradually learn to gauge your tolerance for risk as well as the location of your stops, or the point at which you want to end a losing trade. You can then begin searching for trade opportunities that will provide a profit consistent with your ratio.
It takes effort and time for a trader to advance. Analysis and introspection after a trading day are essential to your development. Recall that if you wish to get better, you still have work to do after you close your final transaction of the day!
Best of luck!
