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2024/05
Finding the right balance: Win Rate vs. Risk-Reward Ratio
For traders aiming to achieve profit targets, there are generally two directions of effort: continuously improving the trading win rate or continuously expanding the risk-reward ratio.
Theoretically, the risk-reward ratio and win rate balance each other out. The higher the risk-reward ratio, the lower the win rate, and vice versa. So, should investors pursue a high win rate or risk-reward ratio in trading?
Risk-Reward Ratio vs Win Rate: A high win rate does not ensure consistent profitability
As the name suggests, the win rate is the probability of winning. For example, if you make 10 trades and make money on 6 of them, your win rate is 60%.
On the other hand, the risk-reward ratio is the ratio obtained by dividing the average profit points earned by making money in multiple trades by the average loss points incurred by stop-loss.
If each trade profits 15% but the stop-loss is 5%, then the risk-reward ratio is 3.
Theoretically, the market spends 80% of its time in a range and 20% in a trending market.
Taking international gold as an example, in a ranging trend, you can short sell near the previous high-intensity resistance zone when the gold price rises to it.
With a stop-loss of 3 units and a take-profit of 9 units, or a stop-loss of 5 units and a take-profit of 15 units (choose according to market volatility), or buy when the gold price falls to the previous low-intensity support zone, using the same take-profit and stop-loss strategy.
But regardless of which approach is used (both with a risk-reward ratio of 3:1), making 3 successful trades out of 10 (a win rate of 30%) can achieve profitability.
- Stop-loss of 3 units x 7 trades = 21 units; take-profit of 9 units x 3 trades = 27 units; profit = 27 – 21 = 6 units.
- Stop-loss of 5 units x 7 trades = 35 units; take-profit of 15 units x 3 trades = 45 units; profit = 45 – 35 = 10 units.
But what if it’s the other way around? With a win rate of 70% and a risk-reward ratio of 1:3, the long-term trading result is a loss. This example illustrates the importance of investors often overlooking the risk-reward ratio.
The relationship between Win Rate and Risk-Reward Ratio affects final profits
The above touches the tip of the iceberg of how win rate and risk-reward ratio affect profits. The following text will make hypothetical reasoning and statistics: assuming a monthly profit target of 5%, with an average of 60 trades per month, when the win rate drops from 70% to 35%, and the risk-reward ratio changes from 0.5:1 to 3:1.
If the win rate is high (such as 60-70%), achieving a risk-reward ratio of around 1:1 can meet the target.
In the case of a win rate of 50%, a risk-reward ratio of 1:1 and 0.5:1 is ineffective.
If the win rate is meager (below 40%), a risk-reward ratio of 3:1 is more reasonable, and trading with a risk-reward ratio of 2:1 carries exceptionally high risk.
Reality tells us that no one can guarantee a consistently high win rate.
Bruce, an American trading system design and application expert, has been trading since 1975 and entered the trading system research and design field in 1976.
He once said, “For professional traders, the profit trading percentage is often less than 40%.”
Even professional traders, let alone ordinary retail investors, find maintaining a high win rate challenging.
While the win rate is crucial in trading, focusing too much on increasing the win rate may yield minimal results.
Increasing the Risk-Reward Ratio is the Key to Profitability
From the calculation formula of the risk-reward ratio (profit/loss), we can find ways to increase the risk-reward ratio:
- Increase the average profit per trade, i.e.
- Increase the numerator.
- Decrease the average loss per trade, i.e.
- Reduce the denominator.
The first method to achieve these two points is to increase the profit per trade and decrease the loss per trade.
As the saying goes on Wall Street, “Cut losses short and let profits run.” In this method, investors may find it difficult to control how far the profit can “run,” but they can control the maximum loss per trade, also known as stop-loss.
How to effectively increase the Risk-Reward Ratio?
Set a maximum loss per trade or establish exit conditions. Once these conditions are met, sell even if there is a loss.
This controls the extent of losses, preventing significant losses from being deeply trapped. This is also one of the essential reasons for stop-loss.
However, although the extent of profit is difficult to control, the position size during profit and loss is controllable.
This involves the second method of increasing the risk-reward ratio—position management. Decreasing the position size for losses and increasing the position size for profits can also increase the risk-reward ratio.
However, the risk-reward ratio is a lagging indicator, requiring statistics after many trades, and it is challenging to guide entry based on the risk-reward ratio.
Forcing the risk-reward ratio may result in profit turning into losses or missing out on market trends. Therefore, investors should formulate plans for trading.
After achieving profitability according to the plan, they can set a compulsory exit point at the cost line to at least ensure no losses.
Under the premise of ensuring floating profit space, you can moderately hold profits to seek more excellent market trends to expand the risk-reward ratio.
Over time, the profit space will also increase day by day. When determining the win rate and risk-reward ratio, you can use the famous Kelly formula: q = p – (1 – p) / R (p is the win rate, R is the risk-reward ratio) to calculate the optimal position size.
