Risk Reward Ratio and Profit Expectation in Forex Trading

In the world of forex trading, there's a commonly repeated assumption that if you're not willing to bear losses, the likelihood of making a profit will be small ("no pain, no gain"). Another assumption is that you should set profit targets larger than the risk you take in each of your trades. This is reflected in various expressions such as "always ensure the ratio between reward and risk is greater than 1", "only trade with a minimum risk-reward ratio of 1:1.5", and so on.

These expressions emphasize the importance of having the reward always greater than the risk, or in other words, the risk-reward ratio should be greater than 1:1, ideally reaching 1:1.5 or even 1:2. Many traders believe that by having a high risk-reward ratio, they can easily make a profit even if the percentage of profitable trades (win percentage) is small. However, in reality, there are many traders who succeed by always setting the risk greater than the expected profit target.

The key to success lies in having a higher percentage of profit than the percentage of loss in overall trading. To measure the overall probability of profit from your trading, the term profit expectancy or expectancy is used. Profit expectancy can be calculated using four main parameters:

• Percentage of profit from overall trading (winning trades), denoted as W%
• Percentage of loss from overall trading (losing trades), denoted as L%
• Average profit size in a winning trade, denoted as Av W
• Average loss size in a losing trade, denoted as Av L

The formula for calculating profit expectancy is as follows:

Profit expectancy = (W% x Av W) - (L% x Av L)

Profit expectancy depicts the amount of profit you can expect from a number of trades you have made. To ensure the reliability of the results, it is recommended to backtest your trading system on a demo account, at least in 50 trades.

For example, if a trader backtests for 6 months with a total of 900 trades, and the results are as follows:

• W% = 70%
• L% = 30%
• Av W = $200
• Av L = $420

Then, the trader's profit expectancy can be calculated as follows:

(0.7 x $200) - (0.3 x $420) = $140 - $126 = $14

This means, the trader can expect a profit of $1400 if they make 100 trades. This indicates that the trader has a probability of making $1400 profit after 100 trades. Of course, their trading results may be slightly better or worse than their profit expectancy, but the probability approaches $1400 after 100 trades.

Traders who only focus on risk-reward ratio, but have a win percentage (W%) smaller than their loss percentage (L%), are likely to have a negative profit expectancy or even incur losses. Therefore, it's crucial to backtest your trading system to determine its profitability.

Although ideally the risk-reward ratio is greater than 1:1 and W% is greater than L%, in reality, market conditions do not always allow for enforcing a larger reward than risk. The most important thing is to pay attention to the percentage of profit and loss by backtesting your trading system to obtain a realistic profit expectancy figure.

 

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