What it means
Many people judge a strategy only by how often it wins, but that tells half the story. A trader who wins 70% of the time can still lose money if the occasional loss is huge, while a trader who wins just 40% of the time can do very well if the wins are much larger than the losses.
The profit/loss ratio captures this by dividing the average profit on winning trades by the average loss on losing trades. If wins average $1,500 and losses average $1,000, the ratio is 1.5, which means each win is worth one and a half losses.
The ratio is most useful when combined with the win rate (the percentage of trades that finish in profit). Together they give the expectancy, which is the average profit or loss you can expect per trade, and a positive expectancy is what you need to earn money over time.
A related and useful calculation is the breakeven win rate, which shows how often you must win for the strategy to cover itself at a given ratio. The higher the profit/loss ratio, the lower the win rate you can survive on, which is why many successful strategies accept losing often while keeping losses small.
The term is also sometimes used in a looser sense to compare total profits with total losses across a period, which is more commonly called the profit factor. It is worth confirming which calculation a report is using, because the two can give different answers on the same set of trades.
In practice
Real-world examples.
Example
A currency trader risks $200 on each trade and aims for $600 when she is right, giving a target profit/loss ratio of 3. She can lose three trades out of every four and still break even, since one $600 win offsets three $200 losses.
Example
A venture investor reviews a portfolio of 20 start-ups. Fifteen lose an average of $100,000 each, while five return an average of $1,200,000 each, so his average win is 12 times his average loss even though only 25% of investments succeed.
Example
A sales manager applies the idea to proposals. Her team wins 30% of bids at an average gross profit of $90,000 and loses bidding costs of $10,000 on the rest, which gives a ratio of 9 and shows that bidding widely is worthwhile.
Formula
Calculation
The formulas are:
Profit/loss ratio = Average winning trade / Average losing trade
Expectancy per trade = (Win rate x Average win) - (Loss rate x Average loss)
Breakeven win rate = 1 / (1 + Profit/loss ratio)
Suppose a trader makes 40 trades. There are 24 winners totalling $36,000 and 16 losers totalling $16,000.
Average win = $36,000 / 24 = $1,500. Average loss = $16,000 / 16 = $1,000.
Profit/loss ratio = $1,500 / $1,000 = 1.5.
Win rate = 24 / 40 = 60%, so the loss rate is 40%.
Expectancy = (0.60 x $1,500) - (0.40 x $1,000) = $900 - $400 = $500 per trade.
Breakeven win rate = 1 / (1 + 1.5) = 1 / 2.5 = 40%, so this trader has room to be wrong more often before the strategy stops paying.Case study
Seen in the real world.
Northgate Trading is an illustrative, fictional proprietary desk with a young trader who bragged about winning 75% of his trades. His results for the year, however, were flat.
When the desk head calculated his profit/loss ratio, she found that his average win was $400 and his average loss was $1,600, a ratio of just 0.25. His expectancy was (0.75 x $400) - (0.25 x $1,600) = $300 - $400, which is a loss of $100 per trade.
She asked him to cut losing trades at $400 instead of waiting for them to recover. His win rate fell to 55%, but with an average loss of $400 and an average win of $450 his expectancy turned positive. The illustrative lesson is that win rate alone can flatter a strategy that is actually losing money.
Watch out
Common mistakes.
- Focusing on win rate and ignoring the size of wins and losses, which can hide a strategy that loses money despite winning most of the time.
- Calculating the ratio from a small number of trades, so a single lucky win or unlucky loss distorts the result.
- Confusing the profit/loss ratio with the profit factor, which compares total profits to total losses and is affected by how many trades there were.
Questions
People also ask.
What is a good profit/loss ratio?
There is no universal answer, because it depends on the win rate, though many traders aim for at least 1.5 to 2 unless their win rate is very high.
Can the ratio be too high?
A very high ratio can mean the trader holds winners well but may also mean the win rate is very low, so confidence in the results needs a large sample of trades.
Does the ratio apply to businesses as well as traders?
Yes, any activity with repeated bets, such as bids, product launches or investments, can be assessed by comparing the average gain from successes with the average cost of failures.
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