What is the profit / loss ratio?
The profit / loss ratio acts as a dashboard for an active trader whose primary motivation is to maximize trading gains. The profit / loss ratio is the average profit on winning trades divided by the average loss on losing trades over a specified period of time.
Profit and loss ratio=NWT.Total gain??TNLTotal lossor:NWT.=number of winning trades
Profit / loss ratio explained
The profit / loss ratio measures the performance of a trading strategy or system. Obviously, the higher the ratio, the better. Many trading books call for at least a 2: 1 ratio. For example, if a system had a winning average of $ 750 per trade and an average loss over the same period of $ 250 per trade, then the profit / loss ratio would be 3: 1. A consistently strong profit / loss ratio can encourage a trader to take advantage of betting on the same strategy with the aim of generating larger absolute profits. Conversely, an unacceptable profit / loss ratio would lead to a review of the strategy or the system implemented to find the weak links. Perhaps the trader will decide to abandon a strategy or system altogether if the ratio does not produce sufficient gains or even causes capital losses.
Thinking beyond the ratio
The profit / loss ratio can be an overly simplistic way of looking at performance because it does not take into account the probabilities of gains or losses for transactions. A concept called Average Return Per Transaction (APPT) may be more insightful. The APPT is the average amount that a trader can expect to gain or lose per trade. The APPT is the difference between a) the product of the probability of winning and the average winning; and b) the product of the probability of loss and the average loss. As an example, let’s take 10 trades, three of which were profitable and seven were losing. The probability of winning is therefore 30% and the probability of losing is 70%. Additionally, suppose the average winning trade was $ 600 and the average losing trade was $ 300. The APT is (30% x $ 600) lower (70% x 300) or -30 $. So even though the profit / loss ratio was 2: 1 ($ 600: $ 300), the trading strategy is actually a losing strategy in terms of probability.