When trading in the forex or other markets, we are often told about a running money management strategy that requires the average profit to be greater than the average loss per trade. It’s easy to assume that these common tips must be true. However, if we take a closer look at the relationship between profits and losses, it is clear that older and commonly accepted ideas may need to be adjusted.
Key points to remember
- Traders often view the profit / loss ratio, which is the proportion of the size of the winning trades to the losers, as a sign of success and profitability.
- A profit / loss ratio greater than 2 to 1 is often sought after, but this simple measure can be a bit misleading as some transactions are inherently riskier than others.
- Average Profitability Per Transaction (APPT) is perhaps a better measure of business proficiency because it takes into account the statistical probability that a transaction will be profitable.
Profit / loss ratio
A profit / loss ratio refers to the size of the average profit relative 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, then your profit / loss ratio is 3: 1— $ 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 earn per trade, your potential loss should. be capped at $ 100.
At first glance, most people would agree with this recommendation. After all, shouldn’t every potential loss be kept as small as possible and every potential profit as large as possible? The answer is, not always. In fact, this common advice can be misleading and harm your trading account.
The general advice to have a profit / loss ratio of at least 2: 1 or 3: 1 per trade is simplistic as it does not take into account the practical realities of the forex market (or any other market), the style of the individual’s trading, and the individual’s average profitability factor (APPT), also called statistical expectation.
The importance of average profitability per transaction (APPT)
APPT basically refers to the average amount you can expect to win or lose per trade. Most people are so focused on balancing their profit / loss ratios or on the precision of their trading approach that they ignore the bigger picture: your trading performance largely depends on your APPT. .
Here is the formula for APPT:
APPT = (PW×AW) – (PL×AL)or:PW = Probability of winningAW = Average victoryPL = Probability of lossAL = Average loss
Let’s explore the APPT of each following hypothetical scenario:
Let’s say that out of 10 trades you place, you profit from three of them and make a loss out of seven. So your probability of winning is 30%, or 0.3, while your probability of losing is 70%, or 0.7. Your average winning trade is $ 600 and your average loss is $ 300.
In this scenario, the APPT is:
As you can see the APPT is a negative number which means that for every trade you place you might lose $ 30. It’s a losing proposition!
Even though the profit / loss ratio is 2: 1, this trading approach only produces winning trades 30% of the time, which negates the supposed advantage of having a 2: 1 profit / loss ratio.
Now let’s explore the APPT of a trading approach that has a 1: 3 profit / loss ratio but has more winning than losing trades. Let’s say that out of the 10 trades you place, you make a profit on eight of them and realize a loss on two trades. Your average winning trade is $ 100 and your average loss is $ 300.
Here is the APP:
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 you trade in the forex market, there is no one-size-fits-all approach to money management or trading. Traditional advice, such as making sure your profit is greater than your absolute trade loss, doesn’t have much substantial value in the real trading world, unless you have a high probability of making a winning trade. . What matters is that your APPT is positive and that your overall profits exceed your overall losses.