Profit/Loss Ratios: The Myth And Relationship Between Profit And Loss Ratios
It is a commonly held belief in the strategy of money management that claims that it is required that the average loss per trade should be lesser than the average profit trade. But while it is easy to uphold this advice as true, if we take a closer look into the concept of profit and loss, it becomes obvious how necessary the old belief must now be adjusted. Profit/Loss Ratios: The myth and relationship between profit and loss ratios – what are the key takeaways?
Important Takeaways Of The Profit/Loss Ratios
Traders are used to considering the ratio of profit/loss as a measurement of profitability and success.
Traders often sought after a profit/loss ratio which is in excess of 2-to-1. But since some traders are more risk takers than others, this simple metric can seem quite misleading.
Average Profit Per Trade (APPT) is more or less a preferable trading skill measurement as it effects in the statistical possibility that a trade will be even more profitable.
What Is Profit/Loss Ratio?
A profit/loss ratio is used to refer to the average profit which is specified in relation to the size average loss to a trade. For instance, if you have an estimated profit of $900 and an estimated loss of $300 on a specific trade, since $900 divided by $300 is 3, your profit/loss ratio will be 3:1.
Many professionals and books suggest a profit/loss ratio of a minimum of 2:1 or 3:1. This means that your potential loss for every $200 or $300 should be capped at $100.
From a distance, this recommendation will easily be embraced as a very logical one. We think should there not be a potential loss that is kept as little as possible and also profit as big as possible?
Well, this doesn’t have to be. And this widely accepted advice can mislead and be potentially harmful to your trading account.
The one-fit-all advice of having at least 2:1 or 3:1 profit/loss broadly simple but doesn’t consider the practical realities of the total markets, the trading pattern of each individual and the individual’s average profitability per trade (APPT) factor, which is also called ‘statistical expectancy’.
The Benefits Of Average Profitability Per Trade (APPT)
The Average Profitability Per Trade (APPT) is generally referred to as the average amount a trader could profit or lose per each trade. A lot of people put so much focus on either having an accurate trading approach or having a balance of their profit/loss ratios. But they neglect or are oblivious of the larger picture which is that the performance of your trade is largely dependent on your Average profitability per trade.
Here Is The Formula For Finding The Average Profitability Per Trade
APPT = (PW×AW) − (PL×AL)
PW = Probability of win, AW = Average win
PL = Probability of loss, AL = Average loss
Let’s Check Out The Average Profitability Per Trade of these Hypothetical scenarios
Let’s assume that in a scenario of 10 trades you embark on, you profited on 3 and had losses on 7. This means that you had only 0.3 or 30% probability of winning. And 0.7. or 70% probability of making losses. Your average loss is $300 and winning trade makes $600.
So, in this first scenario, the APPT is:
(0.3 \times \$600) – (0.7 \times \$300) = – \$30(0.3×$600)−(0.7×$300)=−$30
From what we have, given in the above stat, the APPT is a negative number. And that means that you will experience loss of $30 from every trade you place. And that’s a losing proposition.
So, despite the fact that the profit/loss ratio is 2:1, there is winning trade produced by this trading approach only 30% of the time. And that opposes the popular benefit of having a 2:1 profit/loss ratio.
In the second scenario, we’ll determine The Average Profitability Per Trade (APPT) of a trading approach with a 1:3 profit/loss ratio but with much more winning trades as against the losing ones. Then assume you make a profit of 8 out of 10 trades, which is a two-trade loss.
Here is the Average Profitability Per Trade:
(0.8 \times \$100) – (0.2 \times \$300) = \$20(0.8×$100)−(0.2×$300)=$20
In the second scenario, despite the fact that the trading approach has a 1:3 profit/loss, the APPT is still positive. And it indicates that there is the potential of you profiting over time.
There Are Potential Ways Of Becoming Profitable
So, if you are into forex trading, there is no single trading or management approach that perfectly applies to all. Hence, in the actual trading world, the conventional advice such as ensuring that you have a higher profit to your loss per absolute trade doesn’t have a strong ground, except there’s a high probability for you to have a winning trade. Your APPT turns up positive and that your total profits are higher than you absolute losses.