It makes sense to believe that if you win more trades than you lose, you'd be turning a profit with your trading strategy. However, winning trades don't always equal profit at the end of the day.
Day traders
should be assessing the quality of their wins and losses. Quality in day
trading means that a trader's win/loss ratio, risk/reward ratio, acceptable
losses, and acceptable risks are all taken into account when creating a bid or
ask.
By
addressing all of these elements, you create a balance between your win rate
and risk/reward ratios, which is crucial to success as a day trader. You should
be striving for a win rate of between 50% and 70%, and try to trade at
risk/reward ratios of 1.0 for a higher win rate (60% to 70%), and between .60
and .65 for lower win rates (40% to 50%).
Key
Takeaways
·
- Day traders must understand the
win/loss ratio, risk/reward ratio, and win rate to be successful.
·
- Win/loss and win rate metrics tell
you how often you are winning vs. losing money on your trades.
·
- Your risk/reward ratio expresses
how much you're willing to risk losing vs. how much you could win on your
trades.
·
- In general, you should aim for a
win rate of 50% to 70%, a win/loss ratio above 1.0, and a risk/reward ratio
below 1.0.
Day
Trading Win/Loss Ratio
Most day
traders focus on the win rate or win/loss ratio. The allure is to eventually
reach that stage where nearly all of their trades are winners. While that
appears to make sense, having a high win rate doesn't mean that you'll be
a successful trader or even a profitable one.
Your win
rate shows how many trades you win out of all your trades. For example, if you
make five trades a day and win three, your daily win rate is three out of five,
or 60%. If there are 20 trading days in the month, and you win 60 out of 100
trades, your monthly win rate is 60%.
The
win/loss ratio is your wins divided by your losses. In the example, suppose for
the sake of simplicity that 60 trades were winners, and 40 were losers. Your
win/loss ratio would be 60/40 = 1.5. That would mean that you are winning 50%
more often than you are losing.
A win/loss
ratio above 1.0, or a win rate above 50%, is favorable, but it isn't an
indicator of overall success. You might be winning, but if your losses are
larger in value than your wins, you are still not profiting. You should
consider your risk/reward ratio at the same time.
Day
Trading Risk/Reward Ratios
A
risk/reward ratio is how much you expect to make on a trade, relative to how
much you're willing to lose.
Day traders
want to be in and out of the market quickly, taking advantage of short-term
patterns and trade signals. This typically means each trade will have
a stop-loss attached to it. The stop-loss determines how
many cents, ticks, or pips you are willing to risk in a stock,
future, or forex pair.
Assume you
are willing to risk $0.10 on stock XZYZ, buying it at $10.00 and placing a
stop-loss at $9.90.
Your risk
is fixed at $0.10 (assuming no slippage), but you must be compensated for
taking this risk with a potential profit as well. Your profit target
establishes your expected payoff.
Analyzing
Your Risk to Reward
Suppose,
based on your analysis or trading strategy that you believe the price will
reach $10.20, at which point you will take profit, resulting in a $0.20 gain.
Your
potential reward therefore would be twice as large as your potential risk. Your
risk/reward ratio would be $0.10/$0.20=0.5; in other words, your risk would be
half of your potential gain.
If you were
to take profit at $10.10, your potential profit and risk would both be
$0.10, so the risk/reward ratio would be $0.10/$0.10 = 1.0. If you were to
take profit at $10.05, your potential risk would be $0.10, but your reward
would only be $0.05. In that case, the risk/reward ratio would increase to 2.0,
showing that you are risking more to make less.
A lower
risk/reward ratio is preferred when trading. Even a trader with a higher risk
tolerance should be trading with a low risk/reward ratio to maximize their
profitability and minimize losses.
Balancing
Win Rate and Risk/Reward in Day Trading
Day traders
must strike a balance between win rate and risk/reward. A high win rate means
nothing if the risk/reward is very high, and a great risk/reward ratio may mean
nothing if the win rate is very low. Consider one of the following strategies:
·
A higher win rate means that
your risk/reward can be higher. You can still be profitable with a 60% win rate
and a risk/reward of 1.0. You'll be more profitable with a 60% win rate and a risk/reward
below 1.0.
·
A low win rate, 50% or below,
requires winners to be larger than losers in order for you to be profitable.
You can still be profitable with a 40% win rate if risk/reward is below
0.6 (excluding commissions).
·
Ideally, if your win rate is below
50%, strive for a risk/reward below 0.65, with the risk/reward decreasing the
more the win rate drops. The more you lose, the bigger your winners must be
when you do win.
Day
Trade at Your Peak Ratios
Since day
traders trade every day in all types of conditions, most should seek out a
strategy that allows them to win between 50% and 70% of the time. Winning more
than that becomes increasingly difficult, with minor additional payoffs.
This win
rate allows for some flexibility in the risk/reward ratio. Strive to make a bit
more on winners than you lose on losers; ideally, wins should be about 1.5
times greater than risk—if risking $0.10 try to make at least $0.15. This
risk/reward ratio is 0.67.
Keep your
risk/reward below 1.0; that way, even if you have an off day, winning only 40%
of your trades, you can likely still pull off a daily profit.
Your ideal
mix will depend on your trading style. Keep in mind that you don't need a
very high win rate or a super-low risk/reward ratio to be successful. Strike a
balance, and strive for consistency.
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