Profitable and consistent trading is about finding a balance between your win-rate and risk/reward ratio. Here’s how to do it.
I have multiple strategies. Some have higher win-rates, others lower, some have high reward:risk, some have lower.
Win-rate is how many trades you win, usually given as a percentage. Such as 50%, 5 out of 10, or 50 out of 100. That means 50% of trades placed result in a profit.
Win rate is what many people focus on. They want to be right, often! Yet reward:risk (R:R) is just as important. R:R is how much a trader wins on winning trades versus how much they lose on a losing trade.
If you risk $100—that is what you lose when you take a loss—but make $500 on a winner, you can have a low win-rate and still make money because your profitable trades are so much bigger than your losses.
If you lose $1,000 when you take a loss, but only make $150 when you win, it will be nearly impossible to increase the account over time because you will need to win 8 out of 10 trades to eke out a profit.
I use the reward:risk so that we can work in real numbers. 2:1, 1.5:1, 3:1 etc, or you could just say your reward is 3x your risk in the latter case. Risk/reward is another term used, and means the same thing, except then you are using a fraction. If your reward is 3x your risk, the risk/reward is 1/3, or 0.3333. I prefer using reward:risk.
Trading Win Rate and Reward-to-Risk Averages
Over many trades, I will end up with an average R:R and an average win-rate. It is these averages, over time, that matter…based on closed trades.
If you strive to make 20:1 R:R trades every time, but the price never hits your target, you end up with a bunch of losses and a non-existent reward. You need to be able to actually lock in those Rewards in order for it to matter.
Each trade is important—we need to execute as best we can—but we also want to think about how the strategy performs over many trades.
You Can Have a High Win-Rate and Low R:R, or a High R:R and a Low Win Rate
Most people think they need to accurately predict where the market is going to make money. That is not true.
Think of trading as mathematical. Using win-rate and reward:risk you can determine what balance of those two you require to be profitable.
Profits can come regardless of how many losses you have, assuming your wins are big enough to compensate. Losses can be mentally draining if you want to be right all the time, but if your goal is to make money, losses are just a part of trading.
I think of it this way:
Imagine someone tells you they have a strategy that can produce $12,000 in income per month on a $20,000 account. In order to get the $12,000 at the end of the month, you need to place 30 trades. You are going to lose $400 of your capital on 20 of them (each). On the other 10 trades, your average gain is $2,000 (5:1 reward to risk). These wins and losses are randomly sprinkled over the month.
20 X -$400 = -$8,000 in losses
10 X $2,000 = 20,000 in wins
Total profit= + $12,000
Would you do it? Of course. But once we start trading we think “If I can cut out a few of those losses, I make even more money.” Or “I don’t want to lose on a trade, so I won’t take trades I think might be losers.” Or “I just lost 4 trades in a row. I can’t handle another possible loss. I am sitting the next trade out.” Totally forgetting that we need to take those losing trades to get our monthly profit. And so we deviate. We need those 20 losses in order to find those 10 winners that give us a nice profit. You can’t have one without the other.
The example is meant to show that big returns are possible even with a low win-rate. This trader only wins 33% of their trades, yet is making a huge monthly return.
Another trader could make nearly $10K, potentially, but they win 60% of the time and use a reward to risk of 2:1 on 30 trades.
12 losses X -$400 = -$4800
18 wins X 800 = $14, 400
Profit = +$9,600
This is not meant to say higher-reward to risk strategies are better because the first traders made more. The statistics could be altered in many ways to provide different scenarios. One way isn’t better than another, but if you have a low win rate you need a higher reward:risk, and if you have a high rate you can get away with a lower reward:risk.
A high win rate and low reward to risk seems to appeal to many people, because it seems easier and less emotional to have more wins, even if they are smaller.
But make no mistake, it is not any easier. Winning 60% of trades with a 1:1 R:R or greater is actually pretty rarified air. Most traders win less than 50% of their trades.
And those people you see claiming they win 90% of their trades…they usually “blow up” their account because they are taking lots of tiny profits, but a few big losses wipe them out.
Trying to win a lot of trades is just as hard as withstanding more losses for a few big winners that produce an overall profit. That said, a certain combination is best for YOU. Find out what it is that you feel most comfortable with. Go by what you feel in actual trades (less stress, more confident, etc.), not what you think you would prefer.
The Biggest Problems People Face with Risk/Reward and Win Rate
One of the biggest problems certain traders have is holding a trade all the way to the target, whatever it may be. The problem tends to get more pronounced the bigger the reward:risk is. Holding the trade all way to a 10:1 target may be difficult for some people (yet very exhilarating and exciting for others). People that have a hard time holding onto profitable trades tend to jump ship before the target is reached. Once a trade is showing a profit, they are afraid of losing the small profit they have. So they close the trade with a small profit and miss out on the bigger potential. But if you hold all your losses and cut your profits early, your income evaporates.
Consider what kind of trader you are. Would you rather have big winning trades where you just sit back and watch them unfold? Or would you rather collect smaller gains more often? One is not better than another, but going against your nature is wrong and will result in frustration and likely failure. Know yourself, and then create a strategy around it.
Another thing to consider is that you need to have losing trades to capture the profitable trades. Profitable trades are typically worth more than a losing trade (assuming a higher than 1:1 reward:risk), so if you start trying to “skip” losing trades, and you skip a winner by accident, that is REALLY going to hurt. You just gave up $2,000 trying to avoid a $400 loss (5:1), or gave up $800 to avoid a $400 loss (2:1)!
Trying to avoid losses is likely the biggest problem for many traders. Losses mess with our heads and our capital, so there is strong incentive to avoid them. Let me try to reframe that problem for you with an anology:
I hire you to implement MY strategy for me. I give you all the rules and all you have to do is follow. You are not trading. You are just following my instructions/strategy, similar to putting together Ikea furniture. If you follow the rules I will give you a $10,000 salary per month.
$10,000 is the maximum I will pay you for implementing my strategy, because that is how much the strategy makes in a month based on the capital I have allocated to you.
But, for each mistake you make I will deduct $1,000 from your pay. If you make 10 mistakes in a month—taking a trade that wasn’t part of the strategy, getting out early, getting in early, not taking a valid trade, wrong position size, not setting a stop loss, holding a loss or profit longer than strategized, etc.—your income is down to $0.
Would you take this job, placing, let’s say, 30 trades a month? That’s all you have to do it execute 30 trades correctly and make $10K? You could probably do it in your spare time! Do you think that would be easier than trading on your own?
That IS trading! That IS your job as a trader! But your boss isn’t me, it is YOU and your strategy, and it’s the market that deducts your pay for mistakes. Reducing mistakes (your action versus the strategy) is the easiest way to start making serious money. Yet, few monitor their mistakes or try to improve on them. Instead, they try another strategy and make the same mistakes.
Your strategy and capital define your salary. It is your profit potential. Don’t try to make more than your salary dictates by deviating from your strategy. If you want a bigger salary, create better or more strategies.
If you think you could follow my strategy rules to get paid $10K a month to enter and exit 30 trades, then do it for yourself! This scenario is your life as a trader, but hopefully, it makes you think about trading in a different light and will help you stick to your strategy better.
Follow your trading rules and strategies. Capture your salary that is owed to you, and don’t dwindle it away on mistakes.
Strategy Determines the Average Win-Rate and Reward:Risk
Your strategy determines what your win rate and R:R will be. But you get to write your strategy based on your preferences and your goals.
Once you understand position size, you can create massive reward:risk ratios based on relatively small price moves.
You don’t need to use the same reward:risk on every trade. You can let the market determine it (I will explain shortly), but only take trades when the reward:risk is favorable (above 1:1). On a side note, this is why you should never trade binary options. Wining 70% of your wagered capital on a trade seems alluring, but people foreget they are risking 100%. You win less than you lose (0.7:1), the opposite of what you want. Even a winning hand in blackjack has a payout of 1:1!
As a swing trader, for example, you may see the price is approaching the top of an expanding range on the daily chart. You decide to drop down to an hourly chart, and then a 15-minute chart, watching for signs that that price is starting to reverse lower.
You enter short and place a stop loss 50 pips above the entry, just above the recent swing high. You place a target 375 pips away, near the bottom of the expanding range.
This is a nearly 8:1 reward-to-risk trade. Or 8R for short. The target is not outlandish, it is based on movements the price has made recently.
The example below, based on a forex swing trading strategy, provided two chances for entry. The trade provided a big boost to the account and lasted 4 days.
Charts from TradingView.
A day trader could find a simar setup that lasts a few minutes to an hour or so. They may find a nice small consolidation near a support or resistance level that allows them to use a 4 pips stop loss, yet based on the recent price action they can reasonably expect a 30 pip move over the next few price waves. That’s a 7.5R trade.
Or a day trader could routinely take 1.5:1 or 2:1 reward:risk trades, locking in smaller gains throughout the day, like discussed in the Day Trading Stocks with a Trend Following Strategy or the EURUSD Technical Turnaround Day Trading Strategy.
Here’s an example on the EURUSD 1 minute chart.
A swing traders could do something similar, or go for bigger R:R ratios like discussed above.
But How Do You Know?
The question that always comes up is “But how do I know the price will run X amount to hit my 10:1 target, my 2:1 target, my 5:1 target, etc.?”
You don’t! And you never will. That’s why you just need to place targets based on rational levels, that are based on a tested and verified strategy. That way you’ll have confidence in the trades you take, even if some (or lots) of them don’t work out. Sometimes the price runs to them, and other times it doesn’t. Remember, you only need a few wins to overcome a lot of losses when you use a high reward:risk. And the smaller your reward:risk typically the easier it will be to get a higher win rate.
Your strategy testing and practicing should tell you what you can expect in terms of win rate and risk/reward. If you don’t like the results, change the strategy.
Let math do the work. If you structured your strategy well and have verified that it works, let it play out. Collect your salary without deductions!
Trailing Stop Losses
Profit targets are not required. Trailing stop losses can also be used. Your strategy testing will still reveal your win rate and average reward:risk over many trades.
Trailing stop losses can be very effective at times. For instance, Renko charts, which can be used used as a trailing stop loss, are effective in strong trending periods. In day-to-day conditions when price action is choppier, profit targets are the better choice as the trailing stop will likely close the trade at inopportune times.
Profit Problems Fixed
If you track your win-rate and R:R you can typically find your problem. Go through your trades, see if you can make a bit more on them. Maybe you are taking profit too early. Or maybe your profit targets, on average, are just a tiny bit too far out, so they aren’t being reached and the price reverses. Decrease your reward:risk slightly. Or better yet, see if you can reduce your risk. Then you can keep your reward:risk about the same, but your target is closer to the entry point.
Maybe your entries are poor so the price is reversing after you enter and not giving you the chance to capture those big gains. Where is the profit potential in relation to your entry? Was it before, did it come after? Fine-tune your entry based on what you discover.
When you track and look at these statistics, they will tell you what you need to do to improve.
Final Word on Win-Rate and Reward-to-Risk
I like getting the odd high R trade, but also grabbing consistent 2:1 (forex day trading) and 3:1 (stock swing trading) trades. If you can snag the odd, 10R or 20R trade, that covers a huge amount of losses. You don’t always need to go for those types of trades…trade the reward:risk the market is providing. Sometimes that is 5:1, or 3:1 or 8:1. Sometimes it is 30:1.
Think about if you added one or two 20R or 30R trades per year. If you risk 1% of your capital per trade, that one trade increases your account by 20% or 30%. That’s a huge addition to the bottom line.
The other option is nailing quick profits regularly, seeking a higher win-rate but typically having a lower reward:risk. I do this most of the time, taking 2:1 and 3:1 trades, but I am aware of certain market conditions where I may be able to get a much larger profit. In those cases I remain open to expanding my profit target or using a trailing stop loss to potentially grab a really big profit. In your trading plan, specify under what conditions you will try for small R:R or bigger R:R.
Your profit zone is somewhere out there, a balance between your win-rate and reward-to-risk. You may not need to change your whole strategy if you are struggling. A couple of small tweaks could turn a loss into a win, or increase the average R of your trades.
By Cory Mitchell, CMT
Disclaimer: Nothing in this article is personal investment advice, or advice to buy or sell anything. Trading is risky and can result in substantial losses, even more than deposited if using leverage.