Win-Rate, Reward-to-Risk, and Finding the Profitable Balance
Cory Mitchell, CMT
I have multiple strategies. Some have higher win-rates, others lower, some have high reward:risk, some have lower.
Win-rate is how many trades you win, usually given as a percentage. Such as 50%, 5 out of 10, or 50 out of 100. That means 50% of trades placed result in a profit.
Win-rate is what many people focus on. They want to be right! Yet reward:risk (R:R) is just as important. R:R is how much a trader wins on winning trades versus how much they lose on a losing trade.
If you risk $100—that is what you lose when you take a loss—but make $500 on a winner, you can have a low win-rate and still make money.
If you lose $1,000 when you take a loss, but only make $150 when you win, it will be nearly impossible to increase the account over time because you will need to win 8 out of 10 trades to eke out a profit.
On each trade, I determine my entry, stop loss, and how far the price can reasonably move before a potential reversal. This provides my estimated reward:risk for the trade.
Over many trades, I will end up with an average R:R and an average win-rate. It is these averages over time that matter...based on closed trades.
If you strive to make 20:1 R:R trades every time, but the price never hits your target, you end up with a bunch of losses and a negative reward:risk. You need to be able to actually lock in those Rewards into order for it to matter.
Each trade is important—we need to execute as best we can—but we also want to think about how the strategy performs over many trades.
Don't Be Afraid to Lose
Most people think they need to accurately predict where the market is going to make money. That is not true.
Think of trading as mathematical. Using win-rate and reward:risk you can determine what type of trades you need to be profitable.
Profits can come regardless of losses. Losses can be mentally draining if you want to be right all the time, but if your goal is to make money, losses are just a part of that.
I think of it this way:
Imagine someone tells you they have a strategy that can produce $12,000 of income per month on a $20,000 account. In order to get the $12,000 at the end of the month, you need to place 30 trades. You are going to lose $400 of your capital on 20 of them (each). On the other 10 trades, your average gain is $2,000 (5:1 reward to risk). These wins and losses are randomly sprinkled over the month.
20 x -$400 = -$8,000 in losses
10 x $2,000 = 20,000 in wins
Total profit= + $12,000
Would you do it? Of course. But most of us instantly start to think "If I can cut out a few of those losses, I make even more money." And so we deviate. But we need those 20 losses in order to find those 10 winners that give us a nice profit. You can't have one without the other.
Probably the biggest problem is holding a trade all the way to the 5:1 target. Usually once a trade is showing a profit, people are afraid of losing it. So they close the trade with a small profit and miss out on the bigger potential.
Another thing to consider is that you need to take trades to capture the profitable trade. Profitable trades are worth more than a losing trade (assuming a higher than 1:1 reward:risk), so if you start trying to "skip" losing trades, and you skip a winner by accident, that is REALLY going to hurt. You just gave up $2,000 trying to avoid a $400 loss!
The example is meant to show that big returns are possible, even with a low win-rate. This trader only wins 33% of their trades, yet is making a huge monthly return.
The key thing is to let the profits run. If a trader gets anxious and cuts a few of those winners only taking a tiny profit, then the strategy could become unprofitable. A low win rate requires capturing big profits every once in a while.
Strategy Determines the Average Win-Rate and Reward:Risk
The above analogy is simply the statistics for a strategy; a feasible one.
Once you understand position size, you can create massive reward:risk ratios based on relatively small price moves.
You don't need to use the same reward:risk on every trade. You can let the market determine it (will explain shortly), but only take trades when the reward:risk is favorable.
As a swing trader, for example, you may see the price is approaching the top of an expanding range on the daily chart. You decide to drop down to an hourly chart, and then a 15-minute chart, watching for signs that that price is starting to reverse lower.
You enter short and place a stop loss 50 pips above the entry, just above the recent swing high. You place a target 375 pips away, near the bottom of the expanding range.
This is a nearly 8:1 reward-to-risk trade. Or 8R for short. The target is not outlandish, it is based on movements the price has done recently.
To see how to place targets, and trade, based on these types of price structures, check out the following video. The article continues after.
I like to put targets near the other end of price structures, but not all the way. If I am going short, I will place my target above the price structure low, and if going long below the price structure high.
The example below provided two chances for entry. The trade provided a big boost to the account and lasted 4 days.
A day trader could find a simar setup that lasts a few minutes to an hour or so. They may find a nice small consolidation near a support or resistance level that allows them to use a 4 pips stop loss, yet based on the recent price action they can reasonably expect a 30 pip move over the next few price waves. That's a 7.5R trade.
But How Do You Know?
The question that always comes up is "But how do you know the price will run 375 pips or 30 pips so you can make that big profit (high R)?"
You don't! And you never will. That's why you just need to place targets based on rational levels. Sometimes the price runs to them, and other times it doesn't. Remember, you only need a few wins to overcome a lot of losses when you use a high reward:risk.
Let math do the work! You can't predict everything anyway, so why bother. Pick spots that allow for a small risk relative to a big potential reward. Then let it play out so you can collect your cheque at the end of the month.
Trailing Stop Losses
Profit targets are not required. Trailing stop losses can also be used. Your strategy testing or results should show that the trailing stop loss method used produces a profit overall. This typically means it catches some large winners.
Trailing stop loss can be very effective at times. For instance, Renko charts, which can be used used as a trailing stop loss, are very effective in strong trending periods. In day-to-day conditions when price action is choppier, profit targets are the better choice as the trailing stop will likely close the trade at inopportune times.
There is another option: strive for a high win-rate. A high win-rate typically means the average reward:risk is going to be smaller. Markets reverse and chop around too much to have a win-rate and a high reward:risk.
If you win 60% of your trades, you can have a 1:1 R:R and still make money. Lose $1,000 or make $1,000, but win more often than you lose.
This appeals to a lot more people. It seems easier, and less emotionally stressful.
But make no mistake, it is not any easier. Winning 60% of trades with a 1:1 R:R or greater is actually pretty rarified air. Most traders win less than 50% of their trades.
And those people you see claiming they win 90% of their trades...they usually "blow up" their account because they are taking lots of tiny profits, but a few big losses wipe them out.
Trying to win a lot of trades is just as hard as withstanding more losses for a few big winners that produce an overall profit.
Profit Problems Fixed
If you track your win-rate and R:R you can typically find your problem. Go through your trades, see if you can make a bit more on them. Maybe you are taking profit too early.
Maybe your entries are poor so the price is reversing after you enter and not giving you the chance to capture those big gains.
When you track and look at these statistics, they will tell you what you need to do to improve.
Final Word on Win-Rate and Reward-to-Risk
I like getting the odd high R trade. If you can snag a 20R trade, that covers a huge amount of losses. You don't always need to go for those types of trades...trade the reward:risk the market is providing. Sometimes that is 5:1, or 3:1 or 8:1. Sometimes it is 30:1.
Think about if you added one or two 20R or 30R trades per year. If you risk 2% of your capital per trade, that one trade increases your account by 40 or 60%. That's a huge addition to the bottom line.
The other option is nailing way quick profits, seeking a higher win-rate but typically having a lower reward:risk.
Your profit zone is somewhere out there, a balance between your win-rate and reward-to-risk. You may not need to change your whole strategy if you are struggling. A couple of small tweaks could turn a loss into a win, or increase the average R of your trades.
By Cory Mitchell, CMT. Join me on Twitter @corymitc.
Disclaimer: Nothing in this article is personal investment advice, or advice to buy or sell anything. Trading is risky and can result in substantial losses, even more than deposited if using leverage.