“It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.” – George Soros
Looking at the below chart you will see that the bigger your wins are versus your losses the lower your winning percentage can be and you remain profitable.
A primary dynamic of trading that is over looked as traders chase hot stocks, trends, and chart patterns is the importance of taking trades that have the potential to be big wins or small losses. Big losses will kill your account quickly and small wins will do little to pay for those losses.Our trades have to be asymmetric where our downside is carefully planned and managed, but our upside is open ended. This is a crucial element for trading success and has to be understood and planned for.
The risk/reward ratio is used by more experienced traders to compare the expected profits of a trade to the amount of money risked to capture profit. This ratio is calculated mathematically by dividing the amount of profit the trader expects to have made when the position is closed (the reward) by the amount the trader could lose if price moves in the unprofitable direction and the trader is stopped out for a loss.
A big secret that many rich traders know that new traders do not is that the winning percentage for even the best traders is only about 50%-60%. Having big winning trades and small losing trades is a trading edge.
The skill of cutting losses short is a primary driver of a profitable trader’s ability to make money. Big losses are the primary reason most new traders are unprofitable.
- With a 1:1 risk/reward ratio and 50% win rate a trader breaks even.
- With a 2:1 risk/reward ratio and about a 35% win rate a trader breaks even.
- With a 3:1 risk/reward ratio and about a 25% win rate a trader breaks even.
The big takeaway is that the bigger your winning trades are versus your losing trades, the lower your win rate has to be to become profitable. The lower your win rate has to be, the better your odds are that you will be profitable as a trader. You don’t have to be right all the time; you just have to be right big and wrong small.
- With a 3:1 risk/reward ratio, you only have to be right over 25% of the time to be profitable. This is a powerful principle to understand.
The methodology for determining your risk/reward ratio begins with first determining where price has to go to show you that your expected outcome is not going to happen. This is the key support level and what you use to place your stop loss. You can set your target for a rally to a key resistance level or a new all-time high. That will be your potential profit target. Your stop loss level is your risk and your target is your reward. Allowing one of the two to play out is the key to skewing your trading to have a high risk/reward ratio and increase your odds of profitability.
The errors of letting a loser run through your stop loss and create a big losing trade or taking a profit quickly and eliminating a big winning trade are what undermines this ratio and creates unprofitable trading in many instances. High winning percentages are difficult for the vast majority of traders, especially with tight stop losses. It is a much simpler path to profitability to ride trends in your trading time frame instead of trying to be right about every entry.
A great formula to use is a 3:1 risk/reward ratio. With this ratio a trader is risking $100 to make $300. If 100 shares of stock are bought for $30 a share and the stop is at $29 then the stock should only be purchased if it is probable that the stock could run to $33. At a $33 share price, profits could be taken or, ideally, if it runs to $34, a trailing stop could be set at $33 to give the stock an opportunity to be an even bigger winner. Remember, though, set the trailing stop to lock in the $3 per share gain.
If you follow this plan, after ten trades your account could look like this:
- Lose $100
- Make $300
- Lose $100
- Make $300
- Lose $100
- Make $300
- Lose $100
- Make $300
- Lose $100
- Make $300
Profit $1,000 with only a 50% win rate!
However if you allow losers to run, hoping they will come back so you can take profits on a rebound, then you can get into trouble fast.
What if the stock you were trading fell from $30 to $29, you didn’t stop out, and it kept falling to $20? What if you started wanting to lock in profits at $31 and not let your winner run? The dynamics of your risk/reward ratio would change, leaving you unprofitable even though you had an 80% win rate.
- Lose $1000
- Make $100
- Lose $500
- Make $200
- Make $100
- Make $100
- Make $200
- Make $100
- Make $100
- Make $100
Lost $500 even with an 80% win rate!
Remember that you can cut losses even shorter if you are proven wrong before your stop is hit, but at the same time you have to allow enough room for normal fluctuations and volatility in your stop and use position sizing that you are comfortable with for your trading account size.
- Allow winners to run as far as possible with the use of trailing stops. You never know when you could have a huge win with the right entry and trend.
- Know how much you will risk on any one trade then do not enter a trade where the upside is not at least three times your risk of loss if your stop is hit.
It is not the winning percentage of a trader that determines their profitability, but the size of all their winning trades versus the size of all their losing trades. This is the math that determines profitability.