Common Myths About Profit/Loss Ratio

05/31/2011 8:00 am EST

Focus: STRATEGIES

Before accepting the widely held beliefs about profit/loss ratio, take a look at these stats, which clearly show that another measure of profitability—average profitability per trade—is more important.

When trading any security or market, we are often told of a common money management strategy that requires that the average profit be more than the average loss per trade. It's easy to assume that such common advice must be true. However, if we take a deeper look at the relationship between profit and loss (P&L), it is clear that the "old," commonly held ideas may need to be adjusted.

Decoding Profit/Loss Ratio

A profit/loss ratio refers to the size of the average profit compared to the size of the average loss per trade. For example, if your expected profit is $900 and your expected loss is $300 for a particular trade, your profit/loss ratio is 3:1, which is $900 divided by $300.

Many trading books and "gurus" advocate a profit/loss ratio of at least 2:1 or 3:1, which means that for every $200 or $300 you make per trade, your potential loss should be capped at $100.

At first glance, most people would agree with this recommendation. After all, shouldn't any potential loss be kept as small as possible and any potential profit as large as possible? The answer is, not always. In fact, this common piece of advice can be misleading, and it can actually cause harm to your trading account.

See related: Why P&L Doesn’t Determine Success

The blanket advice of having a profit/loss ratio of at least 2:1 or 3:1 per trade is over-simplistic because it does not take into account the practical realities of the forex market (or any other markets), the individual's trading style, and the individual's average profitability per trade (APPT) factor, which is  also referred to as statistical expectancy.

The Importance of Average Profitability per Trade

Average profitability per trade (APPT) basically refers to the average amount you can expect to win or lose per trade. Most people are so focused on either balancing their profit/loss ratios or on the accuracy of their trading approach that they are unaware that a bigger picture exists. Your trading performance depends largely on your APPT.

This is the formula for average profitability per trade:

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Let's explore the APPT for the following hypothetical scenarios.

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Scenario A

Let's say that out of ten trades you place, you profit on three of them and you realize a loss on seven. Your probability of a win is therefore 30%, or 0.3, while your probability of loss is 70%, or 0.7. Your average winning trade makes $600 and your average loss is $300.

In this scenario, the APPT is: (0.3 x $600) – (0.7 x $300) = - $30

As you can see, the APPT is a negative number, which means that for every trade you place, you are likely to lose $30. That's a losing proposition!

Even though the profit/loss ratio is 2:1, this trading approach produces winning trades only 30% of the time, which negates the supposed benefit of having a 2:1 profit/loss ratio.

Scenario B

Now let's explore the APPT of a trading approach that has a profit/loss ratio of 1:3, but has more winning trades than losing ones. Let's say out of the ten trades you place, you make a profit on eight of them, and you realize a loss on two trades.

Here is the APPT: (0.8 x $100) – (0.2 x $300) = $20

In this case, even though this trading approach has a profit/loss ratio of 1:3, the APPT is positive, which means you can be profitable over time.

Many Ways to Become Profitable

When trading any type of account—retirement or short term—there is no one-size-fits-all money management or trading approach.

Traditional advice, such as making sure your profit is more than your loss per absolute trade, does not have much substantial value in the real trading world unless you have a high probability of realizing a winning trade. What matters is that your APPT comes up positive and that your overall profits are more than your overall losses.

By Grace Cheng, founder and editor, DailyMarkets.com

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