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What is the Win/Loss RatioThe win/loss ratio is the ratio of the total number of winning trades to the number of losing trades. It does not take into account how much was won or lost, but simply if they were winners or losers.
Calculating a Win/Loss RatioThe win/loss ratio is used mostly by day traders to assess their wins and losses. It is used with the win-rate, that is, the number of trades won out of total trades, to determine the probability of a trader’s success. A win/loss ratio above 1.0 or a win-rate above 50% is usually favorable. For example, if you made 30 trades of which 12 were winners and 18 were losers, your win/loss ratio would be 2:3. In percentage format, the win/loss rate is 12/18 = 2/3 = 0.67, which means that you are losing 67% of the time. Your win-rate, or probability of success, would be 12/30 = 40%.
What is a Risk/Reward RatioMany investors use a risk/reward ratio to compare the expected returns of an investment with the amount of risk undertaken to capture these returns. This ratio is calculated mathematically by dividing the amount the individual stands to lose if the price of an asset moves in the unexpected direction (the risk) by the amount of profit the trader expects to have made when the position is closed (the reward). The risk/reward ratio is often used as a measure when trading individual stocks. The optimal risk/reward ratio differs widely among various trading strategies. Some trial and error is usually required to determine which ratio is best for a given trading strategy, and many investors have a pre-specified risk/reward ratio for their investments. In many cases, market strategists find the ideal risk/reward ratio for their investments to be approximately 1:3, or three units of expected return for every one unit of additional risk. Investors can manage risk/reward more directly through the use of stop-loss orders and derivatives such as put options.
What is expectancyExpectancy is what it sounds like. It helps you understand how winners, losers, gains and losses relate to each other over the long term. This process helps you understand what your trading system profits should be, and helps validate your back testing. First, you will calculate your win- and loss-ratios. Second, you will calculate your reward-to-risk ratio. Finally, you will combine the two numbers into an expectancy ratio. That information will help to understand what you can expect in the future.
(Reward to Risk ratio x win ratio) – Loss ratio = Expectancy Ratio
Expectancy is a great way to compare and analyze strategies and strategy modifications. It is a solid double-check on the viability of the strategy itself. If your expectancy ratio is negative you should not trade the strategy.
Expectancy also serves an important planning purpose. I always compare developing an expectancy ratio to the pre-flight checklist that a pilot uses before take off. If you are able to answer all the questions required for an expectancy ratio then you have done some good planning. If one of your trading factors is blank, or only an estimate, you need to solidify it before executing on your system.