The Myth Of Profit/Loss Ratios
When trading the forex market or other markets, we are often told of a common money management strategy that requires that the average profit be more than the average loss per
trade. It's easy to assume that such common advice must be true.
However, if we take a deeper look at the relationship between profit and
loss, it is clear that the "old," commonly held ideas may need to be
adjusted.
Profit/Loss Ratio
A profit/loss ratio refers to the size of the average profit compared to the size of the average loss per trade.
For example, if your expected profit is $900 and your expected loss is
$300 for a particular trade, your profit/loss ratio is 3:1 - which is
$900 divided by $300.
Many trading books and
"gurus" advocate a profit/loss ratio of at least 2:1 or 3:1, which
means that for every $200 or $300 you make per trade, your potential
loss should be capped at $100.
At first glance, most people would agree with this recommendation. After
all, shouldn't any potential loss be kept as small as possible and any
potential profitbe
as large as possible? The answer is, not always. In fact, this common
piece of advice can be misleading, and can cause harm to your trading account.
The blanket advice of having a profit/loss ratio of at least 2:1 or 3:1
per trade is over-simplistic because it does not take into account the
practical realities of the forex market (or
any other markets), the individual's trading style and the individual's
average profitability per trade (APPT) factor, which is also referred
to as statistical expectancy.
The Importance of Average Profitability Per Trade
Average profitability per trade (APPT) basically refers to the average
amount you can expect to win or lose per trade. Most people are so
focused on either balancing their profit/loss ratios or on the accuracy
of their trading approach that they are unaware that a bigger picture
exists: Your trading performance depends largely on your APPT.
This is the formula for average profitability per trade:
Let's explore the APPT of the following hypothetical scenarios:
Scenario A:
Let's say that out of 10 trades you place, you profit on three of them
and you realize a loss on seven. Your probability of a win is therefor
30%, or 0.3, while your probability of loss is 70%, or 0.7. Your average
winning trade makes $600 and your average loss is $300.
In this scenario, the APPT is:
As you can see, the APPT is a negative number, which means that for
every trade you place, you are likely to lose $30. That's a losing
proposition!
Even though the profit/loss ratio is 2:1, this trading approach produces
winning trades only 30% of the time, which negates the supposed benefit
of having a 2:1 profit/loss ratio.
Scenario B:
Now let's explore the APPT of a trading approach that has a profit/loss
ratio of 1:3, but has more winning trades than losing ones. Let's say
out of the 10 trades you place, you make profit on eight of them, and
you realize a loss on two trades.
Here is the APPT:
In this case, even though this trading approach has a profit/loss ratio
of 1:3, the APPT is positive, which means you can be profitable over
time.
Many Ways of Becoming Profitable
When trading the forex market, there is no one-size-fits-all money
management or trading approach. Traditional advice, such as making sure
your profit is more than your loss per absolute trade, does not have
much substantial value in the real trading world unless you have a high
probability of realizing a winning trade. What matters is that your APPT
comes up positive and that your overall profits are more than your
overall losses.
No comments