The Myth of Profit/Loss Ratios

When trading on 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 older, commonly held ideas may need to be adjusted.

Key Takeaways

• Traders often look to the profit/loss ratio—that is, the proportion of the size of winning trades to losers—as a sign of success and profitability.
• A profit/loss ratio in excess of 2-to-1 is often sought after, but this simple metric can be a bit misleading since some trades are inherently riskier than others.
• Average profitability per trade (APPT) is perhaps a better measure of trading skill, as it factors in the statistical probability that a trade will be profitable.

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, then your profit/loss ratio is 3:1—$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 profit be as large as possible? The answer is, not always. In fact, this common piece of advice can be misleading and can harm your trading account.

The blanket advice of having a profit/loss ratio of at least 2:1 or 3:1 per trade is oversimplistic 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 (APPT)

APPT basically refers to the average amount that you can expect to win or lose per trade. Most people are so focused on 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 APPT:

​APPT = (PW×AW) − (PL×AL)where:PW = Probability of winAW = Average winPL = Probability of lossAL = Average loss​

Let’s explore the APPT of each following hypothetical scenario:

Scenario A

Let’s say that out of 10 trades you place, you profit on three of them and realize a loss on seven. Your probability of a win is therefore 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:

(0.3×$600)−(0.7×$300)=−$30

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 that out of the 10 trades you place, you make a profit on eight of them and realize a loss on two trades. Your average winning trade makes $100, and your average loss is $300.

Here is the APPT:

(0.8×$100)−(0.2×$300)=$20

In this case, even though this trading approach has a profit/loss ratio of 1:3, the APPT is positive, which means that you can be profitable over time.

Many Ways of Becoming Profitable

When trading on the forex market, there is no one-size-fits-all money management or trading approach. Traditional advice, such as making sure that 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 exceed your overall losses.

Read the original article on Investopedia.