Risk/Reward Ratio vs. Winning Percentage

The facts show that the risk/reward ratio, not winning percentage, is the real key to becoming profitable and sustaining a career as a trader for the long term.

The Search for a Winning Strategy is not Always Right

Most currency traders spend countless hours looking for a magical combination of indicators that will reveal the “holy grail” of trading strategies.

The goal is to find a winning strategy, but more often than not, “winning” is misconstrued into finding a strategy that wins a high percentage of trades. After all, “winning” means making money and “losing” means losing money, right? Don’t be so sure about that.

Like many of the seemingly apparent components that go into creating an excellent trading plan and becoming a great trader, things that seem logical in reality are holding us back.

This may not be the first time you have read something similar to this, and it will not be the last. Along with other ways to think regarding probabilities, the following is an example of something I genuinely believe needs to be not just understood but ingrained into the subconscious of our trading psyche (if through nothing more than repetition) to ultimately eliminate emotion from every single trade we place.

This may be the most challenging aspect of becoming a professional trader, but a trait that one simply must have to stand any chance of survival – both financially, and psychologically.

Being Profitable doesn’t Mean a High Winning Ratio

Being a profitable trader is not just about winning percentages. In other words, you can earn positive returns without winning most, or even a majority, of your trades!

It is all about risk versus reward. If your strategy allows you to identify trading opportunities that offer more reward than risk, then a 50% winning ratio could yield a significantly positive return over time.

The $10000 Example

For example, let’s assume a $10,000 trading account where ten trades are placed, and $100 (1%) is put at risk for each trade.

If risk/reward is 1 to 1, then a 50% win ratio results in a “break-even” return:

[10 trades placed] x [50% losers] = [5 losses] x [$100] = [$500 loss]

[10 trades placed] x [50% winners] = [5 wins] x [$100] = [$500 profit]

[$500 profit] – [$500 loss] = [$0]

If risk-to-reward is 1 to 1.5, then that same 50% win ratio results in a positive return:

[10 trades placed] x [50% losers] = [5 losses] x [$100] = [$500 loss]

[10 trades placed] x [50% winners] = [5 wins] x [$150] = [$750 profit]

[$750 profit) – [$500 loss] = [$250 profit]

In terms of percentage return, this second (profitable) example results in a 2.5% return based on the starting account balance (total equity) of $10,000 after just ten trades. Of course, this is the case when just 1% of total equity is put at risk.

If 3% ($300) is put at risk (a rather high amount for most veteran traders), this same example (same track record) yields a 7.5% return.

In other words, greater profits are achieved based on the exact same performance:

[10 trades placed] x [50% losers] = [5 losses x $300] = [$1,500 loss]

[10 trades placed] x [50% winners] = [5 wins x $450] = [$2,250 profit]

[$2,250 profit] – [$1,500 loss] = [$750 profit]

See Why a Higher Win Rate Can Be Less Profitable Over Time

Conversely, a high winning percentage (which typically necessitates a bigger margin for error or greater risk) may actually result in smaller, less profitable returns over time.

This occurs when the average risk is higher than the average reward. For example, using the same hypothetical $10,000 account that is risking 3% ($300), let’s assume an 80% win ratio with an average risk/reward ratio of 2 to 1.

[10 trades placed] x [20% losers] = [2 losses x $300] = [$600 loss]

[10 trades placed] x [80% winners] = [8 wins x $150] = [$1,200 profit]

[$1,200 profit) – [$600 loss] = [$600 profit]

So, a trader that boasts an 80% win ratio may actually be less profitable than the trader with a seemingly unimpressive 50% win ratio. The question is – do you want to be right, or do you want to make money?

Believe it or not, even negative returns are possible with a higher winning percentage when risk far outweighs reward, so make sure to factor this in when performing due diligence in assessing a strategy and/or track-record results.

Hopefully, this demonstrates the importance of assessing the risk to reward in addition to winning percentage when trying to determine the actual success or profitability of a trading strategy/track record.

Long-Term Profitability is the Real Trading Success

Remember, trading success is not just about winning and losing individual trades – it is about sustaining profitability over time (making money and holding on to those profits in the long run).

The most common mistake newer traders make is in determining the success of a trading strategy (i.e., track record) based on winning percentage alone. This can be quite misleading when risk/reward is not taken into account.

Most new traders (unknowingly in most cases) are willing to risk far more than they are looking to gain (reward) just to be “right,” or win on each trade.

Another excellent piece of advice is that trading is all about making profits over time, not about trading ego (which is usually the result of focusing just on winning percentages). In other words, significant returns can be achieved when you allow yourself to look at the big picture. As the saying goes, “Ten dimes make a dollar.”

The key is to determine entries and exits in advance so that risk/reward can be determined. This will significantly help to keep the decision-making process as consistent and mechanical as possible, which is essential regardless of the technical/fundamental strategy that is used because it helps to eliminate emotions when making trading decisions.

Only then can a truly objective decision be made as to whether or not to take a trade since the decision will be based on established/actual results, and not a “gut” feeling or reaction.

Understanding the mathematical law of averages and law of large numbers reinforces this mechanical approach to trading, which, again, is crucial to trading success because mixing emotions with money-based decisions is usually a recipe for disaster!

-Magnus-