Day Trade Using Win Rate and Risk/Reward Ratios
It's not just about winning, but making your winners count
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 doesn'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%).
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 their trades are winners. While this appears to make sense, having a high win rate doesn't mean you'll be a successful trader or even a profitable one.
Your win rate is 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 3 of 5 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, assume for the sake of simplicity that 60 trades were winners and 40 were losers. Your win/loss ratio is 60/40=1.5. This means you are winning 50% of the time more 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 to 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
Assume, 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 is therefore twice as large as your potential risk. Your risk/reward ratio is $0.10/$0.20=0.5; in other words, your risk is half of your potential gain.
If you take profit at $10.10, your potential profit and risk are both $0.10, so the risk/reward ratio is $0.10/$0.10=1.0. If you take profit at $10.05 your potential risk is $0.10 but your reward is only $0.05. In this case, the risk/reward increases 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 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 day traders 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.