Trading Strategy: Understanding the Importance of Risk Reward Ratio and Profit Expectancy

In the forex trading world, the assumption that "no pain, no gain" holds true for many traders. One principle often emphasized is the importance of setting a reward greater than the risk in every trade, reflected in the concept of Risk Reward Ratio. However, how realistic is this concept, and how can we measure profit expectations in more detail?

1. Risk Reward Ratio: Challenges and Realities

• A common concept in trading is ensuring that the reward is greater than the risk. Phrases like "Trading only with a minimum risk-reward ratio of 1:1.5" or "Always ensure that the ratio of reward to risk is greater than 1" are frequently heard. While ideally, this can enhance profit opportunities, in reality, market conditions do not always allow for meeting such requirements.

1. 2. Profit Expectancy and Expectancy

• Profit expectancy, or expectancy, is an important parameter considering several variables, including the percentage of profits (W%), percentage of losses (L%), the average profit in profitable trades (Av W), and the average loss in losing trades (Av L). The profit expectancy formula is: Expectancy = (W% * Av W) - (L% * Av L)

3. Measuring Profit Expectancy through Backtesting

• Before implementing a trading system in a live account, it is highly recommended to conduct backtesting. By backtesting as many trades as possible, traders can identify realistic profit and loss percentages. For example, Trader A's backtest results with W% = 70%, L% = 30%, Av W = $200, and Av L = $420 yield a profit expectancy of $14.

4. Practical Example: Trader A

• With these backtest results, Trader A can project that if they use their trading system 100 times, their probability of profit is $1400. Although actual results may fluctuate slightly, the probability approaches this figure after 100 trades.

5. Importance of Focusing on Profitability

• Focusing solely on risk-reward ratio without considering profit and loss percentages can result in a negative profit expectancy. Therefore, it is important not only to focus on the desired reward size but also to conduct backtesting to understand how profitable the trading system is.

While the risk-reward ratio plays an important role in trading, actual success lies in the percentage of profits and losses generated by the trading system. Realistic profit expectancy, measured through backtesting, provides a more accurate depiction of profit potential and risk. Wise traders will always integrate the concept of risk-reward ratio with profit expectancy data to make more informed and empowered trading decisions.

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