Day trading is considered pretty risky because you need to actively trade in almost any market condition. While aiming to win in most trades is important, one shouldn't forget about the risk/reward ratio.
Day trading is a method where you buy and sell assets within the same day or even multiple times a day. The idea is to take profit from the frequent short-term price movements within a day. If it's played correctly, day trading can amount to massive profits.
On the other hand, it is also highly risky and can be dangerous for newbies or traders with little to no knowledge of how the market operates and how to make a profit in the short term. Therefore, day traders typically consist of well-educated and well-funded people.
As day trading requires traders to open positions frequently and in any market condition, that means day traders must have a well-balanced strategy and a good risk management system.
If you're a day trader yourself, you must've known that making profits in day trading is not easy. Some day traders believe that their strategies are flawless and their win rates are high, but they still lose some money when the day ends. How so? If this happens to you too, maybe you should consider taking a better look at your risk/reward ratio.
See Also: How to be a Professional Day Trader
Understanding Win Rates and Win/Loss Ratio
Win rate is the number of trades you win out of all your trades. For example, if you open positions 10 times a day and win five of them, your daily win rate is five out of ten or 50%. You can also use the monthly win rate where you calculate the number of wins in a month. Say you win 80 trades out of 100 trades in a month, then your monthly win rate is 80%.
Meanwhile, win/loss ratio is the number of your wins divided by your losses. For instance, if you make 80 wins and 50 losses, your win/loss ratio is 80/50=1.6. This means that you are winning 50% more often than you are losing.
Most day traders only focus on the win rate or win/loss ratio because it sounds logical that the more you win, the higher the chance to profit. While it appears to be accurate, having a high win rate doesn't necessarily guarantee that you'll be a successful trader.
Usually, a win/loss ratio above 1.0 or a win rate above 50% is considered favorable. But remember that it shouldn't be your only indicator of overall success. You might be winning a lot, but you won't be profiting if your losses are bigger in value than your wins. This is why you need to also pay attention to your risk/reward ratio when trading.
Misconceptions about Risk/Reward Ratio
First of all, we must acknowledge that some day traders are still pretty skeptical about risk to reward ratio. They prefer to keep using win rates and believe that it can ensure the safety of their money and keep their trade performance profitable. Here, we're going to address some of the misconceptions that have been circulating around the risk/reward ratio:
- Risk to reward ratio is useless. This is entirely not true because if you combine the risk/reward ratio with other metrics such as win rate, it can actually be one of the most powerful tools, especially in day trading where it's highly risky. Without knowing the risk to reward ratio of a single trade, it is impossible to make a consistent profit, and you'll soon learn why.
- There are bad risk/reward ratios. You might have heard that there’s a "minimum: risk/reward ratio that you should use. Some people would suggest that you need at least a 1:2 risk/reward ratio or higher to make a profit, otherwise it wouldn't be as effective or profitable. The truth is that there is no such thing as good or bad risk/reward ratios. It actually depends on how you make use of it. Remember that the number of your risk/reward ratio should align with your other trading parameters.
- Increasing the high risk/reward ratio can instantly fix bad trades. Some traders would think that if they widen their take profit or shorten their stop loss, they can quickly increase their risk/reward ratio and thus, improve their trading performance. Unfortunately, it's not as simple as that. If you set the take profit too wide, it means that the price will have a hard time reaching it and you will most likely see that your win rate is declining. On the other hand, if you set your stop loss too close, it will increase the chance of early stops, and you will be kicked out of your trades too early.
Understanding Risk/Reward Ratio
A risk/reward ratio refers to how much you expect to make on a trade, relative to how much you're willing to lose. So let's say you bought an asset for $10.00 and you placed a stop-loss at $9.90. If you're willing to risk $0.10, then your potential risk is fixed at $0.10 (assuming no slippage). While this number sounds really small, you should still counter it with a potential profit as well. Your profit target establishes your expected payoff.
See Also: The Dangers of Forex Broker Slippage
If your analysis indicates that the price will reach, say, $10.20 and you place a take profit there, it means that your gain for every winning trade will be $0.20. In other words, your potential reward is twice as large as your potential risk. Therefore, your risk/reward ratio is $0.10/$0.20=0.5. We can say that your risk is half of your potential gain.
If we use a different scenario and place the stop loss at $10.10, then it means that your potential profit and risk are both $0.10 and the risk/reward ratio is $0.10/0.10=1.0. Now, what if you place a take profit at $10.05? Your potential risk is $0.10, but your reward is only $0.05. The increase of the risk/reward ratio to 2.0 shows that you're risking more to make less.
That being said, using a lower risk/reward ratio is considered safer. Even if you have a higher risk tolerance, it's still recommended to trade with a low risk/reward ratio in order to minimize losses.
Why You Need Risk/Reward Ratio
Typically, day traders think that win rate is the most important aspect in trading. But realistically speaking, this is not entirely true. At first glance, it may make sense to believe that if you win more trades than you lose, you'd be taking some money home, not losing them. However, the truth is that even if you do have a higher win rate, there's still a chance that you will end up making a loss.
You can have a win rate as high as 80% and still lose money if the losing trades are so big that they wipe out your winning trades. On the other hand, if you include a risk/reward ratio in your trading plan, it's possible to create a profitable system that aims for only 30-50% win rates.
Instead of focusing on win rates only, day traders should also pay attention to the quality of their wins and losses. The trade quality means that a trader's win/loss ratio, risk/reward ratio, and acceptable losses and risks are all taken into account when opening a buy or sell position.
If you weigh all of these elements in your trades, you will create a balance between your win rate and risk/reward ratio, which is vital for a day trader's success. Make sure that you have a win rate of 50-70% and try to set risk/reward ratios of about 1.0 for a higher win rate (60-70%), or between 0.60 and 0.65 for lower win rates (40-50%).
How to Balance Win Rates and Risk/Reward Ratio in Day Trading
Now that you understand how to measure win rates as well as risk/reward ratio, it's important to know how to balance the two. Having a high win rate won't bring you any good if your risk/reward is also very high. Similarly, a high risk/reward ratio means nothing if the win rate is very low. Here are some tips that you can use:
- A higher win rate means that your risk/reward ratio can be higher. You can still make profits with a 60% win rate and a risk/reward ratio of 1.0. However, the best scenario that you could have is having a higher win rate and a lower risk/reward ratio.
- If your win rate is relatively low, around 50% or below, you should set a higher risk/reward ratio in order to be profitable. You can still be profitable if you have a 40% win rate and risk/reward ratio below 0.6 (excluding commissions). The more you lose, the bigger your win trades must be when you do win.
See Also: How to Build a Winning Trading System
We've learned that win rate isn't the only aspect that you should focus on to make sure that your trades will be profitable. Apart from the win rate, day traders should also pay attention to the risk/reward ratio in every trade. In this case, it's best to try making more profit on winning trades than you lose on losing trades. That way, you can give more flexibility to your win rates. If you keep your risk/reward ratio low (at least under 1.0), then you can still trade profitably even if you get a relatively lower win rate.
When it comes to determining the number of risk/reward ratios, you should balance several parameters, including win rates and risk/reward ratio. Your ideal mix should depend on your trading style, so you don't have to get a super high win rate or set an incredibly low risk/reward ratio to make a good plan. Last but not least, you should acknowledge that your trading plan also plays a massive part in your success. Make sure to set reasonable entry and exit points as well as stop loss and take profit.