There are two ways to earn in trading. The first, mainly used by swing / intraday traders, is the positive risk / reward ratio. Intraday traders, and especially swing traders, generally enter into positions with the highest possible ratios. The second is the winrate or success rate of your trades. But let us return for a moment to these calculations.
Risk / Reward
The risk reward ratio simply represents the maximum loss you allow yourself in comparison to the expected gain. A ratio of 1:4 means that the allowed loss is 1 unit, while the gain is 4, as you would expect, to obtain a statistical advantage that makes you a long-term winner in trading, the ratio you use will be decisive.
It is simply the success rate of your trades. A 60% winrate means that the trader earns on average 6 out of 10 trades.
These two concepts allow you to calculate the success rate you need to be positive.
You trade at $100 per unit and your risk / reward is 1:4, which means that when you lose, you lose one unit is $100 and when your trade is winning, you win 4 units is $400.
Calculation of the winrate required to be “balanced” or “break even”: 1 / (1 + risk / reward)
In our example, with an R/R of 1:4, you only need to be above 20% of the time to be in balance, with no gain or loss (you will still have to take expenses into account).
Equilibrium point: 1 / (1 + (1/4)) = 0.8 or 80% of losing trades so 20% of winning trades. This means that if your trades are winning more than 20% of the time, you will be profitable in the long term.
–> This is why you should focus on trades with a high risk/reward ratio. The higher your ratio, the more you can afford to make losses as only 1 winning trade will compensate for several losing trades.
Swing traders generally have very interesting ratios because this is what allows them to earn in the long term.
But there is a second way to trade profitably: more technical and mainly used by scalpers, it is to have a big winrate. Indeed, many scalpers allow themselves larger losses than the gains (ratio of 3:1, 4:1:1 or even more than 5:1) because their winrate is very high. Indeed, with a winrate of 90%, the scalper can quite easily afford to have a risk reward of 6:1 to be positive.
Calculation: risk / reward ratio of 6: 1 = a risk of 6 units of loss for 1 unit of gain only. But with a winrate of 90%, the trader will win 9 trades out of 10 (+9 units) when he will make only 1 losing trade (for a loss of 6 units).
On 10 trades, the right scalper will have gained 9 units and lost 6 units.
Balance sheet = + 3 units.
It is important to understand these two different ways of being profitable: some will prefer a large winrate, others good ratios. Both can be profitable if done correctly.
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