Understanding the Profitability of Trading.

19 sept. 2023

In the trading world, there are various methods to make money. However, in the fundamental approach to trading itself to earn money, we need to know that it has to be when you win bigger and lose smaller. Then, you might think about whether you should focus on winning more often or bigger. This article explores how to assess the profitability of the trading system with a simple formula.

Winning Rate and Risk-Reward Ratio
Two crucial factors affecting a trading signal's profitability are the winning rate and the risk-reward ratio. The winning rate is the percentage of trades that turn a profit.
A high winning rate can mean steady profits, but it doesn't guarantee overall profitability. The risk-reward ratio is the relationship between potential gains and losses in a trade.
A higher risk-reward ratio can lead to bigger profits, but it also demands a higher rate of correctness to stay profitable.

How They Impact Profitability
Let's use a simple example to understand how these factors affect profitability. Imagine a trading signal with a 60% winning rate and a risk-reward ratio of 2:1.
This means for every $1 risked, the potential profit is $2. If applied to 100 trades with a $100 risk per trade, the total risk is $10,000. Winning 60 trades would yield $12,000 in profit while losing 40 would result in a $4,000 loss.
The net profit in this case would be $8,000. This illustrates how the winning rate and risk-reward ratio impact a trading signal's profitability.

Evaluating Signal Effectiveness
To gauge the effectiveness of a trading signal, you need to consider a few factors.
Firstly, backtest the signal using historical data to assess its performance(Minimum 100 trading signals). Ensure the backtesting period covers various market conditions.
Secondly, forward test the signal using real-time data to evaluate its live performance. Finally, assess the signal's consistency and reliability over time(Real-time experience is different from backtesting). Signals that consistently generate profits are more reliable.

Key Aspects for Profitability
When assessing a trading signal's profitability, focus on a high winning rate and a favorable risk-reward ratio. The signal should adhere to sound trading principles, avoiding subjective factors for consistency and reliability.

The formula for Winning Rate and Risk-Reward Ratio
Here are simple formulas to calculate the winning rate and risk-reward ratio:

• Winning rate = (Number of winning trades / Total number of trades) x 100
  
• Risk-reward ratio = (Average profit per trade / Average loss per trade)
  

The higher these values are, the greater the potential for earning money through trading. However, having high values in isolation isn't enough for profitable trading.

Let's delve into a few examples to fully grasp this concept:

Example 1:
Consider Person A, who has a stellar winning rate of 90%, yet a risk-reward ratio of a meager 0.1. Now let's ask, will this individual amass wealth or rack up losses?
With his current risk-reward ratio, when luck favors, Person A walks away with a hefty $1,000. However, when faced with defeat, he incurs a significant loss of $10,000!
Their trading pattern? Win 9 times with a total earnings of $9,000, only to lose a much larger sum of $10,000 later. While this strategy may appear profitable in the short-run, it's unsustainable in the long-run, often resulting in accumulating losses.

Example 2:
Now, let's consider another scenario. Person B, with a winning rate of only 10% but a remarkable risk-reward ratio of 8. The same question arises - will this person amass wealth or rack up losses?
With their risk-reward ratio, when placed in favorable circumstances, Person B earns an impressive $8,000. Conversely, a bad day costs them a $1,000 loss.
Now, their trading pattern may seem paradoxical. They win once, earning a massive $8,000, then lose 9 times in a row for a total loss of $9,000. Despite the high-risk reward ratio, the low winning rate fails to buoy their profits. Ultimately making it a non-profitable strategy.

Determining Profitability
To assess whether you can make money based solely on the winning rate and risk-reward ratio, consider a formula called the required winning rate. It's defined as:

• Required Winning Rate = 100 / (Risk-Reward Ratio + 1)
  

https://www.tradingview.com/x/PXcBVTIf/

Let's look at two examples:

1. Person A has a 90% winning rate and a risk-reward ratio of 0.1. The required winning rate is 100 / (0.1 + 1) = 90.91%. Person A needs to maintain a winning rate of 90.91% to break even.
   
2. Person B has a 10% winning rate and a risk-reward ratio of 8. The required winning rate is 100 / (8 + 1) = 11.1%. Person B must achieve an 11.1% winning rate to avoid losses.
   

This formula helps determine the minimum winning rate needed to profit based on a strategy's risk-reward ratio. It emphasizes that both factors are critical for trading success. If the required winning rate isn't met, it may be wise to pause and further study the markets.

Assessing the profitability of a trading signal is essential for successful trading. Consider the winning rate, and risk-reward ratio, evaluate the signal's effectiveness, and emphasize key aspects. Use the required winning rate formula to understand the minimum winning rate needed for profitability. By making informed decisions, traders can improve their chances of consistent profits over time.

Follow and Boost for your financial success!
Write your thoughts in the comment section.